Thursday, 20 September 2012

What explains low long-term interest rates: article for Liberal Democrat Voice

[This article was originally published in Liberal Democrat Voice here in response to a specific request to comment on the texts reproduced below. I have made many of the arguments below in previous blogposts, so regular readers may not find much new, but for others it may be a useful summary]. 

As the head of an independent economic research institute, it's not my job to attend the Liberal Democrat conference (or indeed that of any other party).  But, following up an FT article here, I was asked to comment on the text of a motion which argues that:

"Conference recognises that the difficult decisions taken by the Coalition Government have ensured the credibility of the UK government’s position in the financial markets allowing the UK to borrow at record low rates"

and on an amendment:

"Conference also notes that it would be a mistake to attribute record low public sector borrowing costs to accelerated fiscal consolidation rather than to a flight to relative safety."

The original text is economically ignorant nonsense. The amendment is partly correct, although it still gets the underlying explanation wrong at least in part.  The current level of long term interest rates does not reflect "market confidence"; quite the opposite.  Both economic theory and the empirical evidence suggest that the current level of long-term interest rates is primarily the result of economic weakness, not strength. 

First, some theory.  What determines the level of long term interest rates on government debt?  The standard neo-classical view  is that, as the Bank of England puts it in its handy beginners guide to monetary policy, "long-term interest rates are influenced by an average of current and expected future short-term rates".  

In other words, theory suggests that the low level of long-term interest rates in the UK reflects low expected future short-term rates. And what determines expected future short term rates?  Again, the Bank of England is quite clear on this - expected inflation.  And why does the Bank expect inflation to fall sharply in 2012 and perhaps beyond?  Because the economy is weak:  

"Against this background, and that of its most recent projections to be published in the February Inflation Report, the [Monetary Policy] Committee judged that the weak near-term outlook for growth and the  associated downward pressure from slack in the economy meant that, without further monetary stimulus, it was more likely than not that inflation would undershoot the 2% target in the medium term."

So record low public sector borrowing costs simply reflect the weakness of the economy.  Is my analysis widely shared? Let's look at the IMF's last report on the UK:

"Some further slowing of consolidation is unlikely to trigger major market turmoil

43. Further slowing consolidation would likely entail the government reneging on its net debt mandate. Would this trigger an adverse market reaction? Such hypotheticals are impossible to answer definitively, but there is little evidence that it would. In particular, fiscal indicators such as deficit and debt levels appear to be weakly related to government bond yields for advanced economies with monetary independence. Though such simple relationships are only suggestive, they indicate that a moderate increase in the UK’s debt-to-GDP ratio may have small effects on UK sovereign risk premia (though a slower pace of fiscal tightening may increase yields through expectations of higher near-term growth and tighter monetary policy).  This conclusion is further supported by the absence of a market response to the easing of the pace of structural adjustment in the 2011 Autumn Statement. Bond yields in the US and UK during the Great  Recession have also correlated positively with equity price movements, indicating that bond yields have been driven more by growth expectations than fears of a sovereign crisis."

For an IMF report, this is remarkably clear.  It is saying two things.  First, just as I argue above, the reason long-term gilt yields are low in the UK (and similarly in virtually every other "advanced economy with monetary independence") is weak growth, not "confidence" or "credibility".  "Bond yields are driven more by growth expectations."  That is, yields are low not because of economic confidence but because of its exact opposite. This is precisely what I and others 
(Simon Wren-Lewis here, and of course Paul Krugman in the US) have long been arguing.  Indeed, the specific evidence the IMF cites - that yields have fallen when stock markets have fallen - is precisely that, in the UK, I first pointed out here a year ago.  

Second, that there is no reason to believe that slowing fiscal consolidation would "trigger an adverse market reaction".  In other words, when the Chancellor said that "these risks [of slowing consolidation] are very real, not imaginary", he was indulging in evidence-free speculation, not serious analysis.  Indeed, the Fund accurately points out that the main reason yields might rise (slightly, not precipitiously) if fiscal policy were to be loosened would be because of "expectations of higher near-term growth". As I pointed out here, this would be good news.  So, the IMF agrees that the reason gilt yields are low is because of weak growth, not confidence; and that we could loosen policy with minimal risk and probable benefit.  

So what underlies the Treasury's contention that low interest rates reflect "market confidence"? It is, of course, true that reduced default risk should lead to lower interest rates on government debt, just as it should on any other debt. But, as I have pointed out before, there is not and has never been any significant default risk on UK government debt. Nor is there any obvious evidence that movements in interest rates have been related to changes in market perceptions of default risk. As I predicted at the time, Moody's recent decision to put the UK's rating on negative watch had precisely no impact on market interest rates.

Finally, it is worth noting that, if we believed the original motion, the main thing driving interest rates would be the deficit, and in particular market expectations of the deficit going forward. Conveniently, the Treasury publishes a summary of external forecasts of the economy. These forecasts change over time, and here is the average of external forecasts for the deficit in 2013-14, plotted against ten year gilt yields.

Higher deficits lead to higher interest rates?  Not exactly.  If anything, the opposite, certainly over the last year - because, of course, both higher deficits and lower interest rates are driven by economic weakness, precisely as theory predicts.

To conclude, we know, both as a matter of theory and evidence, why long-term interest rates are low.  It reflects the persistent weakness of the UK and international economies.  There is no mystery here.  The original motion simply ignores the facts. 

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