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Portfolio > Economy & Markets > Economic Trends

Rising Rate Consensus Is Wrong: Research Affiliates

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Worried about rising rates? Don’t be.

But there’s ample room to be worried about the reason rates won’t be rising much, which is the same reason real returns for bonds and equities should be low over the coming decade: The economy has downshifted to low growth and low demand.

That dismal forecast from Research Affiliates’ head of macro research, Shane Shepherd, in the Newport Beach, California-based firm’s April commentary flies against the consensus expectation that interest rates are at long last upwardly bound starting with an initial rate hike by the Federal Reserve later this year.

Shepherd draws on recent history to caution those overly influenced by rate-hike rhetoric, reminding readers that the consensus view was that rates would rise in 2010. The non-occurrence of that rate hike didn’t dampen expectations of rising rates in 2011, 2012, 2013 or 2014, either.

In Shepherd’s analysis, it is economic conditions and not Janet Yellen that set long-term rates — no matter how much the Fed chairwoman may protest that she has run out of patience.

Thus, in an economy marked by slow growth, weak employment, stagnant wages and low inflation, the Fed is constrained from raising rates.

The Research Affiliates analyst undertakes to explain how it is that the U.S. economy has yielded to a new economic paradigm following the global financial crisis and pays particular attention to the data that a “data-dependent” Fed is neglecting to publicly address in its rate advisories.

The Fed’s view, following the global crisis, was that a period of low interest rates would be the proverbial spiked punchbowl at the party, stoking growth and putting people back to work.

But neither has genuinely occurred. Shepherd says the output gap — the difference between actual and potential GDP — has not disappeared since the economic recovery got underway, standing today at 16%.

What’s more, while official numbers show that unemployment has fallen from a high of 10% in 2009 to a “full employment” figure of 5.5% today, the reality is very different once the sharp fall in the labor participation rate — from 66.2% in 2008 to 62.8% now — is accounted for.

“If the labor participation ratio were to return to its 2008 level, today’s unemployment rate would sit at 10.4%!” Shepherd writes, adding that it is this shadow labor inventory that explains stagnant wage growth in an economy with a supposedly tightening job market.

Shepherd acknowledges that changing demographics have played some role in the declining rate of work force participation.

Nonetheless, he argues, “it seems peculiar to disregard the fact that the participation rate held steady at 66% — only a percentage point below its all-time peak — from 2003 through 2008, and started falling only in response to the 2009 recession. Surely a combination of long-term demographic trends and cyclical pressures must be at work.” 

So while official statistics seem to suggest that a rate hike may be in order, the true reality — of which Fed officials are aware — tells a different story.

Thus, in Shepherd’s parsing of the Fed’s March statement, the U.S. central bank knows it will need to keep rates lower for longer than it is assumed to believe. The key line from that statement, according to Shepherd:

“The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”

Ideas vary as to what is normal in the long run. Research Affiliates’ Newport Beach colleague Bill Gross of Janus Capital has written often about what he calls the “new neutral rate.”

But according to Research Affiliates’ model, GDP growth trends and demographic variables imply that real interest rates will rise from their current rate of -1.38 to around zero a decade hence.

At this low equilibrium level, real returns on stocks and bonds should be correspondingly low as well. (The firm publishes its rate and return expectations on a quarterly basis.)

While Research Affiliates 10-year GDP growth estimate of 1.5% is lower than that of, say, the Congressional Budget Office’s 2.4%, even the CBO’s estimate is well below that of the U.S.’s historical 3.5% rate — an implicit acknowledgement that the potential growth lost in the current output gap is effectively gone for good.

In today’s economy, “the demand just isn’t there,” Shepherd soberly concludes.

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