It often pays to listen to central bankers. That may seem like an obvious statement. But often you actually have to listen to them – you can’t rely on reports in the media. Every now and then, the most important statements are ignored or under-reported.
This month’s Bank of England (BoE) press conference may be a case in point.
Most reporting is obsessed with the merits and perceived failings of forward guidance. This should not be a surprise. Forward guidance is simultaneously worthy, and a bit of a con. “State contingent” guidance is jargon for what central banks have always done – set interest rates according to economic outcomes. What’s novel is perhaps the more open and explicit link to specific variables and forecasts. So far, this has resulted in very low levels of interest rate expectations at the short end of the yield curve, and very low levels of volatility in rate expectations. This should be helping economic growth.
But the trick involved in forward guidance is also clear. If we believe the forward guidance, it is unlikely to be true. This may have already occurred in the UK, hence all the hand wringing. By convincing everyone that interest rates would not rise for two years, confidence gets boosted at a critical juncture, which means interest rates may have to rise… sooner than expected.
Intriguing as all of this may be, it is ultimately noise. The entire debate suffers from over-analysis and an illusion of control. Much more interesting is what Mark Carney mentioned in passing (17:20 in the video of the conference linked above), but received little attention: that “equilibrium” interest rates have fallen well below past levels. This is important because it bears on one of the most important investment decisions we make; what to do with government bonds.
Now, it is important to be clear about precisely how Carney phrased this. Many economists argue that real interest rates will stay extremely low, because real GDP growth will be low (Larry Summers, for example). But the BoE is not saying that output and growth will not return to trend, it is saying that the level of interest rates consistent with trend growth is much lower than in the past.
This is important because it means you can be optimistic on growth, and bullish of bonds. If the Bank is right, there should be a huge flattening of the yield curve.
The concept of an “equilibrium” real interest rate is not very clearly defined. It can be thought of as the level of interest rates prevailing when the economy is growing at trend, with minimal spare capacity. It can also be thought of as the average level of interest rates likely through an economic cycle. Either way, there is a market price for it, implied by the yield curve.
The best market estimate of “equilibrium” interest rates is probably the 5y5y interest rate derived from bond prices. This is the implied market expectation of where 5-year yields will be in five years time. Currently, the 5y5y rate implied by both the gilt and treasury curves is around 4%.
Carney is not explicit about what he believes is the new equilibrium. He says it is significantly lower than in the past, and during the press conference seems to be suggesting that 3% is a reasonable guess, perhaps lower. Page 40 of the BoE’s inflation report contains a more detailed discussion, suggesting 2-3% is a reasonable assumption.
Most of the reasons given for this decline by the Bank are not particularly interesting: the usual post-crisis mantra of structural headwinds associated with balance sheets and the banking sector – none of which is hugely convincing, or likely to be permanent. More interestingly, the Bank cites the global trend of declining real interest rates, which precedes the financial crisis, and has been going on for decades.
Very few coherent explanations of this trend have been provided, particularly as it has not coincided with lower global trend growth. This will be the subject of a future blog. What is pertinent to bond pricing is that in order for interest rates to approach those implied by the yield curve in the medium-term, not only do the current “headwinds” have to disappear after three years, but also a thirty-year trend has to abruptly reverse. The alternative is that official interest rates persistently sit below those implied by bonds, in other words, bonds are cheap.