Investment Clock insights

Economic times

Ian Kernohan

30 September 2015

The recent decision by the Fed not to raise rates, while dropping broad hints that they will raise rates soon has led to much frustration in markets.  By altering their guidance to include a reference to “financial and international developments”, the Fed are in danger of creating a Gordian knot: they won’t hike if markets are “worried”, but markets are “worried” about a hike too.

The broader economic issue here relates to the neutral, or equilibrium, interest rate.  This is the rate consistent with achieving maximum employment and price stability in medium term. Despite the sharp fall in policy rates in recent decades, inflation around the world remains very low, so it appears that central banks have been accommodating a downward trend in the “equilibrium” rate of interest, and a policy rate that might have been considered inflationary is now contractionary.  It becomes harder to raise rates without squeezing the economy unduly, and this process is self-reinforcing, as low rates foster growing debt levels.

The question for the Fed (and the BOE) is whether the recovery has gained sufficient traction, such that we have reached the point when the interest rate required to keep the economy operating at normal levels of capacity and inflation, is likely to rise.  The international dimension is important here.  If China continues to slow and commodity prices maintain their downward trend, then central banks will want to maintain a strong domestic economy, to offset these external disinflationary factors.

Neutral real rates are likely to stay much lower that their pre-crisis average in the immediate future.  However, we still expect a slow normalisation in rates over period of years.  Looking further ahead might suggest a move back towards the long-term average for real interest rates, unless we feel that the global economy is condemned to decades rather than years of low growth; in short, that the financial shock of 2008/9 was so much greater than any other shock over last 150 years, such that the equilibrium real interest has now fallen permanently. 

The value of your investment and the income from it is not guaranteed and can fall as well as rise. This article is for professional customers only. The views expressed are the author’s own and do not constitute investment advice.