By Julius Probst
The modern business cycle in advanced economies is mostly about nominal shocks that are being transmitted to the real economy. Market monetarists, for example, argue that monetary policy failures are typically responsible for business cycle fluctuations, the Corona shock being the obvious exception.
Given the above, looking at nominal variables is of course very important, though for this post I will also be looking at the real yield curve; nominal yields adjusted for inflation (and inflation expectations).
There are a lot of misconceptions when it comes to interest rates and the stance of monetary policy, and unfortunately modern macroeconomic theory has contributed to this sad state of affairs. While economics 101 teaches us never to reason based on a price change, business newspapers tend to do that all the time. As such, low interest rates are usually associated with easy money, even though this is a dangerous misconception.
Low interest rates are usually a sign that monetary policy has been tight in the past, the reason being that low inflation will push down nominal interest rates via the Fisher effect whereas the liquidity effect only dominates in the short-run (see Milton Friedman for an explanation).
The graph below shows the US yield curve in recent months vs. the beginning of the year. The Corona shock has lowered growth expectations and inflation expectations for years to come, pushing down the entire curve.
The following charts shows a cross-country comparison for several major advanced economies. As one can see, Switzerland, Japan, and Germany have negative nominal yields throughout almost the entire maturity spectrum.
On the other hand, the US, UK, Canada, and Australia have slightly higher nominal yields, especially at the very long-end of the spectrum. This could be attributed to the Fisher effect. Compared to the Eurozone, Japan, and Switzerland, the Anglo-Saxon countries are expected to have higher inflation rates in the medium run, which in turn pushes up nominal yields.
While nominal interest rates are mostly determined by inflation and nominal demand, real interest rates are, to a large extent, a function of the economy ‘s supply side. Across most advanced economies, real interest rates have been on a secular downward trend, a result of adverse demographics, declining total factor productivity, and higher inequality.
As the chart below shows, real rates have decreased from above 5% in the late 1980s to below 0% in recent years.
The bar chart also shows the extent to which inflation adjusted interest rates have fallen in most advanced economies, with the exception of Japan, which in many ways was the precursor in terms of what the global economy would face later on.
In the aftermath of the famous stock and real estate bubble that popped in the 1990s, nominal interest rates crashed towards the zero lower bound and Japan has been experiencing moderate deflation or extremely low inflation for many years.
As one can see, nominal asset prices have never recovered from the burst of the bubble.
As the government was pepping up the economy in the aftermath of the crash, Japan in a way was leading the world in terms of policy responses. Zero interest rate policy, QE, and government spending to make up for the demand deficiency were already a reality in Japan before similar policies were introduced in other advanced economies after 2008.
While the Bank of Japan had a brief spell of quantitative easing in the early 2000s, the massive expansion of the balance sheet started in 2013 with the introduction of Abenomics.
As the chart below shows, Abenomics had a clear reflationary effect on the Japanese economy with nominal GDP finally increasing again, even though arguably the policies implemented did not go far enough since inflation has continued to be below target.
As I explained in my blog post on market monetarism, a large balance sheet is not necessarily a sign that money is easy, but rather that money has been tight in the past.
It is precisely because monetary policy has not been expansionary enough in the past (in terms of hitting the nominal targets) that Central Banks’ balance sheets are expanding so much now.
The chart below shows that inflation rates have also been on a downward trend in recent years, and that the there is some convergence in terms of inflation rates: the spread between the highest inflation rate and the lowest is lower than a decade ago.
While real interest rates are not a great indicator for the stance of monetary policy, they do reveal some important information.
In the chart below, I have calculated the real yield curve (nominal yields minus CPI inflation) for the seven advanced economies we have looked at above.
In real terms, Germany has the most negative yield curve. If you recall, Switzerland had a negative nominal yield curve. But since the country is experiencing deflation, the real yield curve is significantly higher than in some of the other countries. Similarly, Japan is experiencing moderate deflation, which pushes up the real yield curve (compared to the nominal one).
Considering the level of real interest rates, one could argue that monetary policy is really not that accommodative in Japan or Switzerland despite their massive balance sheet expansion.
My view is, monetary policy can only be considered expansionary when inflation rates reach (or overshoot) the 2% target and stay there for a while, pushing down real rates even lower, and not a second before.
Disclaimer: We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of the author. While we think our writers are very smart, Macrobond Financial does not expressly endorse the views presented here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have Macrobond, you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have Macrobond, now you have a great reason to get it.