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The inflationary frenzy sweeping the US and the eurozone has automatically plunged real interest rates – nominal interest rates less inflation – into negative territory. We have to go back to the interwar years or the hyperinflation of the 1970s to find similar cases. Yet the catalysts were quite different then: shortages during the world wars and the oil shock in the 1970s. In many respects, the current situation may seem surreal to economists poring over their economic reference books.
Today, the yields on US 10-year bonds and on 10-year Bunds (Europe’s benchmark) are -3% when corrected for core inflation, i.e. inflation excluding the food and energy sectors. This would be even more negative using overall inflation.
What impact does this have on economic agents?
For the most prudent savers, this represents “the euthanasia of the rentier” as Keynes put it, since inflation is eroding the return on risk-free assets. This means that investors lending to the US or Germany for 10 years would see the purchasing power of their savings fall by over a quarter if this situation were to prevail to maturity. Meanwhile, savers willing to take on greater risk are automatically pushed towards higher yielding assets, which are inherently riskier, with the danger of contributing to speculative bubbles. The current appetite for cryptoassets may well be one of the consequences of this.
For citizens and governments alike, these clearly negative interest rates have the merit of making public debt bearable. Debt pays in real terms, as inflation raises government income above the cost of borrowing. As surreal as this may seem, the state gets rich by taking on debt!
For companies, the cheap cost of debt makes investment projects that were unattractive when real interest rates were much higher now appear profitable. This means that hypothetical profits a long way out in the future can be used to justify the valuation of deeply indebted companies. So there is a real incentive to take on debt and to invest.
For central banks, their dual mandate – to manage inflation and act as the primary lender to governments – looks unrealistic. If they were to respect one of the explicit targets in their mandate of combatting inflation, they would quickly put an end to their asset purchases and raise intervention rates. But this would automatically weaken the governments for which they act as the primary lenders. Ultimately, central banks would risk undermining their own credibility if they were to weaken their own balance sheets. It now seems clear that the implied objective of the mandates of the Fed and the ECB is to hold real rates at no higher than zero, and ideally in negative territory. This explains their reticence over the last few months to commit to initiating rigorous monetary tightening. In the short term, this balancing act seems realistic. But, in the longer term, were inflation to spiral out of control, it could become mission impossible.
As surreal as it may seem, real negative rates are destined to become the new reality.
With Olivier de Berranger, CIO, LFDE