Commentary on Political Economy

Thursday, 31 August 2023


Cent­ral bank­ing has developed an R-star prob­lem

It’s tempt­ing to dis­miss the whole concept of R*, or R-star — the sup­posed “nat­ural” level of interest rates that serves as a tar­get for much of the cent­ral bank­ing world — as yet another point­less the­or­et­ical con­struct by eco­nom­ists suf­fer­ing from an acute degree of phys­ics envy.

Tempt­ing, and cor­rect. The idea of a pseudo-per­fect neut­ral interest rate level that neither stim­u­lates nor slows a strong eco­nomy with stable infla­tion is an attract­ive aca­demic pro­pos­i­tion but when has that ever actu­ally happened in prac­tice?

Even Fed­eral Reserve chair Jay Pow­ell once com­pared using R* to guide mon­et­ary policy with nav­ig­at­ing by stars that keep mov­ing around the sky. At the Jack­son Hole con­fer­ence of cent­ral bankers last week, he added that the sky was also cloudy. Given that, R* hardly sounds like a lode­star we can rely on.

High­light­ing the messi­ness, the New York Fed­eral Reserve — led by a guru in the field, John Wil­li­ams — sus­pen­ded its cal­cu­la­tions for R* dur­ing the pan­demic, and when it resumed pub­lish­ing updates last May it was with a revised model and rejigged his­tory. Which, as Robin Brooks, chief eco­nom­ist of Insti­tute of Inter­na­tional Fin­ance, observed, is a bit like an investor tweak­ing their his­tor­ical returns to make them look bet­ter. “Not cool,” he tweeted.

R* still mat­ters because a lot of influ­en­tial cent­ral bankers think it does. It kind of sig­ni­fies where they think interest rates should the­or­et­ic­ally end up in the long run — even if his­tory pretty clearly shows that in prac­tice they tend to go up until something breaks and then go down until it heals.

But any­way, there is actu­ally a decent proxy for what the mar­ket thinks the long-term “neut­ral” level of interest rates are. More accur­ately — and per­haps more import­antly — it shows the mar­ket’s view of long-term bond yields. And over the past year, it has repriced dra­mat­ic­ally. This is the 10-year, 10year Treas­ury for­ward rate.

It’s derived from the curve of US gov­ern­ment bond mar­ket yields over time and shows what investors think the 10year Treas­ury yield will be in a dec­ade.

After haphaz­ardly sag­ging for sev­eral dec­ades, it plummeted to a record low of about 1.6 per cent in the wake of the pan­demic. But over the past year it has reboun­ded to about 5 per cent — indic­at­ing that investors think that 10-year Treas­ury yields will edge higher and remain elev­ated for the next 10 years.

Its long-term nature strips out a lot of noise and makes it a decent short­hand for what investors reckon R* is, albeit with some caveats.

It’s obvi­ously just a nom­inal rate. You have to plug in some kind of implied or assumed infla­tion rate to get you to a “true” mar­ket-implied R*. It’s also not the most liquid mar­ket in the world, which is why a lot of people prefer fiveyear, five year interest rate swaps.

Moreover, Barclays’ Ajay Rajad­hyak­sha points out that the 10-year, 10-year tends to be heav­ily affected by whatever 10-year and 20-year Treas­ur­ies are doing — and 20-year Treas­ury yields tend to act fun­nily, given the awk­ward matur­ity (it’s cur­rently yield­ing more than the 30-year).

However, instead of being merely flawed proxy for the mar­ket’s view of R*, the 10-year, 10-year can be seen as a “clean­ish” indic­ator of what the bond mar­ket thinks its own long-term future looks like.

It is now show­ing that the long era of low interest rates has passed on. It is no more. It has ceased to be. It’s bereft of life. It rests in peace. It’s hopped the twig, kicked the bucket, shuffled off its mor­tal coil, run down the cur­tain and joined the great fixed income mar­ket in the sky.

Just a few years ago, the 10-year, 10year was sig­nalling that investors thought “low for longer” had become “low forever”. Today it is whis­per­ing that bond yields will still ebb and flow but we will not return to Ye Olde days of zero rate policy for a gen­er­a­tion.

Of course, it’s hard to ignore the fact that the 10-year, 10-year has also been com­ic­ally wrong for quite a while — both con­sist­ently under­es­tim­at­ing how far the low-yield era would go and then over­es­tim­at­ing its dur­ab­il­ity just as things changed in 2022. But unlike R*, the 10-year, 10-year is an actual, real rate with a sig­nal and prac­tical con­sequences.

You could even make the argu­ment (albeit mostly for the hell of it) that it’s even more import­ant than whatever the actual 10-year Treas­ury note is doing, given how per­cep­tions of the future can shape invest­ment decisions today. It’s going to be inter­est­ing to see if this is just another head­fake or whether we really are in a new, dur­able mid-yield era.

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