The Fear Factor in Today’s Interest Rates
Atlantic-hugging policymakers and pundits, buffered by a continent and a large ocean, may not fully appreciate the significant effect on global financial markets that the threat posed by North Korea has had in recent months. But competition for safe assets has clearly heated up.
CAMBRIDGE – Many who attended grade school during the Cold War will remember what they were instructed to do in the event of a nuclear attack. When the siren wailed, US students were told, one should “duck and cover.” Apparently, squatting under your desk with your arms covering your head would save you from nuclear annihilation. If only it were so.
To recall this absurd advice is also to appreciate the current angst now being felt in Japan. Several times in recent weeks, cellphone texts (today’s sirens) have informed the public that the faint streak in the sky overhead is an intercontinental ballistic missile launched by a nuclear-armed 33-year-old dictator with impulse control issues.
This is a manmade threat to the world order that Atlantic-hugging policymakers and pundits, buffered by a continent and a large ocean to their west, may not fully appreciate. But the threat posed by North Korea’s Kim Jong-un has had a significant effect on global financial markets in recent months.
Simply and discouragingly put, sabre-rattling on the Korean Peninsula has increased the risk of direct conflict with the North, which would shatter the relationship between China and the US. Any such conflict would involve massive loss of life and trigger a large regional, perhaps global, contraction in economic activity.
The theory of “rare disaster risk” has progressed considerably in recent years, owing to the work of the Harvard economist Robert Barro. The core insight is that no one can rule out the occurrence of an Old Testament-style event – war, famine, pestilence, or societal collapse. Such disruptions to a settled way of life slash output, consumption, and human welfare. Because they do not happen often, they are far removed from the smooth center of the probability distribution from which baseline scenarios are drawn.
The experience of the Great Recession tells us what to expect from financial markets when output plummets: as inflation tumbles, so do nominal and real (inflation-protected) yields on Treasury bills. The yield curve flattens because owning a long-term term claim on a safe-haven asset is valuable insurance. As yields on Treasury securities fall, other spreads widen relative to them.
In the current context, geopolitical tensions create the remote possibility of a disaster – the odds of which shift daily – that would make everyone much worse off. We claim no special insight into the mind of Kim Jong-un, but knowing that there is an unknowable helps to make sense of current asset prices. In such circumstances, risk-averse investors, especially those more directly in harm’s way along Asia’s Pacific Rim, will want to insure against an adverse event by taking advantage of the expected financial-market effects now. Nominal, real, and inflation-break-even Treasury rates are lower than the cyclical position of the economy warrants, owing to investors’ perception of acyclical and atypical risk.
In a recent speech, Gertjan Vlieghe, a member of the Bank of England’s Monetary Policy Committee, pointed in the same direction. He explained that when future consumption prospects are misshapen relative to the tried-and-true bell curve, so that there seems to be a higher chance of bad outcomes, the market-clearing (or “equilibrium”) real interest rate falls relative to its history.
The growing perception of rare disaster risk has three implications. First, low interest rates do not necessarily indicate that advanced economies are mired in a low-growth trap as a consequence of adverse demographic trends and slow productivity growth. Rather, they tell us that competition for safe assets has heated up.
Second, this is no counsel for government to ramp up spending. The near-term cost of financing deficits is low because households are worried that the possible “seven lean years” will be very lean, indeed. If citizens are storing up for the worst case, are their leaders – even officials concerned about the cyclical management of aggregate demand – justified in throwing caution to the wind?
And, third, low policy interest rates in the advanced economies are not necessarily evidence of ample accommodation by the monetary authorities. This is because monetary-policy ease is measured in terms of the difference between the actual rate and the equilibrium rate. The current low policy rates maintained by the US Federal Reserve, the European Central Bank, and the Bank of Japan may not look so low if the equilibrium rate is actually low.
The idea of rare disaster risk complements other explanations for the current low level of real rates globally. Perhaps the risk of a remote catastrophe is what created the “global saving glut” that former Federal Reserve Chair Ben Bernanke warned about in 2005. And, if government officials are worried about future conflict, they may have greater incentive to push real interest rates lower through “financial repression,” so that they have sufficient budget space to prepare.
These, however, are explanations of longer-term trends. Recognizing the existence of the global savings glut helps us to understand the 15 years after the Asian financial crisis of 1998. Financial repression makes sense of the experience after wars or on other occasions when government debt piles up. Rare disaster risk is most likely a contributing factor in such episodes, and it may be even more relevant for explaining short-term dynamics in financial markets when missiles fly.