In the previous column I discussed the outlook for inflation in the medium and long term. I argued that there are compelling reasons to think that inflation is going to be clearly above the official target of 2% for years. He said we could be entering a new normal.
What about interest rates? Will we return to the very low rates of the last decade? Or, conversely, have we also entered a new era of higher rates? As with inflation, I don’t know what’s going to happen. I can only offer guesswork and do so in a way that is at least consistent with my speculations about inflation.
My guess is that interest rates will not return to the rock-bottom levels of a few years ago. If inflation, as I argued, is between 3% and 4%, very low interest rates –for example, between 0% and 1%– would be too expansive, since the real rate, that is, the nominal rate, discounting inflation, would be at absurdly low levels of -3%. With these real rates, inflation would run wild beyond what is tolerable.
It is true that the authorities have an incentive to maintain a very low, practically zero, or moderately negative real rate. It interests them, since this makes it easier to finance the public deficit and refinance the debt when it comes due. But these objectives can be achieved with rates between 2% and 3%. That is, clearly higher than in the past, but somewhat below inflation rates, so that real rates are only slightly negative.
What are the policies that will allow central banks to steer economies towards this type of scenario? This question cannot be answered without taking into account what happens with fiscal policy. Therefore, I am going to assume that budgetary policies are reasonably neutral and there are no atrocities like those of Mrs Truss in the UK. In this context, the scenario means that the central banks continue with a policy of raising interest rates to fight inflation, but that it is not followed through to the final consequences. In other words, rates are quickly lowered at the slightest sign of recession, even if inflation is not completely subdued.
But beware! In this inflation-tolerant scenario, investors will demand a higher return on their investments in long-term government bonds, to protect themselves from inflationary risk. This will push up bond rates and force central banks to react. Both the ECB and the Fed have announced the gradual reduction of their public debt portfolios. However, it remains to be seen if they will be able to maintain this policy or if, on the contrary, they will succumb to the pressure of the environment and continue to be large holders of debt for many years. If so, bond rates will be high, but slightly less than inflation.
