7  6  Chart 6a  Chart 6b  Stylised effect of drop in discount rate  Decline in expected growth  Chart 6c  Chart 6d  Rise in two sided uncertainty  Rise in downside tail risk  This obviously depends on the sizes of the changes involved. Chart 6(c) simulates the effect of increasing the standard deviation of annual growth from 2% to 3%. Given that, even over the past twenty years, the true figure – for both world and UK growth – has been around 2%, that’s a fairly significant rise. Chart 6(d) shows what happens when you raise the perceived probability of an economic “disaster” by only 1% point (from 3% to 4%) and, although the simulated disaster is indeed very bad (a 20% drop in output) it’s not out of line with some of those that have occurred in the past (Barro 2009)). BIS central bankers’ speeches  Now these are extremely stylised simulations and one should obviously take them with a pinch of salt. Even within this basic framework there are plenty of other things that might have reduced the equilibrium risk-free interest rate.
6  The model, developed by the economist Robert Barro, and based on an earlier idea by Rietz, allows for the effects of one-sided tail risk – the potential for macroeconomic “disasters” – as well as more conventional, two-sided uncertainty (Barro (2009)). The downside skew to growth reduces the risk-free interest rate and pushes up the required return on risky assets. I used this model to speculate about the causes of low investment in a speech a couple of years ago (Broadbent (2012)). BIS central bankers’ speeches  5  simulates a 1%-point decline in expected future growth). They also return less from that point on. Qualitatively, increases in uncertainty have similar effects – they reduce equilibrium interest rates and depress equity prices (Charts 6(c) and 6(d)). But their sizes are rather different. Changes in two-sided uncertainty don’t do that much (6(c)); by contrast, small rises in the perceived chance of very bad economic events can have powerful effects on the risk-free interest rate.7 Intuitively, this makes sense: an asset whose payouts are immune to such disasters are valuable. Even if that downside risk rises by only a little, people are prepared to pay quite a bit more for – and to tolerate lower returns on – the “safe haven” of government debt. And I think it’s plausible, at least, that an increasingly negative skew to global growth expectations might help to explain the divergence between equity and bond yields in Chart 2.