https://www.ft.com/content/d60cdc40-9fec-11ea-b65d-489c67b0d85d https://www.ft.com/content/d60cdc40-9fec-11ea-b65d-489c67b0d85dA permanent state in which the equilibrium nominal interest rate throughout the developed world is at or below the central bank policy rate is, to put it mildly, really worrying.
There are three possible consequences of this.
The first is that the world could be stuck at zero. All the advanced economies may follow the example of Japan since 2016, with interest rates across the entire yield curve stuck at zero, and fiscal policy battling against a continuous rise in government debt ratios. For asset markets, this would represent a low-return world, with demand management becoming increasingly hamstrung in recurring recessions.
With the second, we could have permanent fiscal stimulus and rising debt. Before the full effects of the virus became apparent, Paul Krugman suggested that the US should permanently increase public investment and the budget deficit by 2 per cent of gross domestic product, with the debt ratio eventually rising to 200 per cent of GDP. This would increase equilibrium interest rates, raising the average level of policy rates and bond yields. The yield curve would shift higher and adopt a more normal upward slope, allowing more scope for easing during recessions.
By reversing the trend decline in interest rates, this policy may result in an immediate period of negative returns for both bonds and equities, though the long-term effects are less clear.
And the third could give us very negative interest rates. Japan and the eurozone have attempted to increase scope for active monetary policy by reducing policy rates slightly below zero, eventually dragging bond yields into negative territory. However, as Kenneth Rogoff has argued, this policy could only succeed if pursued far more aggressively, taking policy rates to minus 3 per cent, or even lower, in recessions. By extending the decades-long downward trend in interest rates, this approach would probably prolong high returns from both bonds and equities.
The political feasibility of these extremely radical fiscal and monetary policy changes seems highly questionable.
