Some stylised experiments affecting the natural interest rate So if it’s not monetary policy, what might have caused the long decline in the real risk-free rate of interest in the past twenty years or so, both before and since the financial crisis? Chart 3 provides a basic visual framework for thinking about these things. What follows, based on a simple asset-pricing model, gives a slightly more quantitative flavour. Any such model will generally allow for three sorts of influences on asset prices: the underlying discount rate (the extent to which people care less about the future than the present), expected economic growth and the degree of uncertainty about that growth. The particular model I’m using here allows for two sorts of uncertainty – a generalised, two-sided risk and, on top of that, the possibility of a large downside hit to growth.6 The first of these terms is connected with saving. All else equal, a lower discount rate means people want to save more – at the margin, they’re prepared to tolerate a lower rate of return on any asset. In terms of Chart 3 you can think of this as a rightwards shift in the saving schedule. In the simple model, the effect of a 1%-point drop in the discount rate on the risk-free interest rate and the value of equities is shown in Chart 6(a). Interest rates fall and, at least on impact, equity prices jump. This is because the present value of future profits increases, not because the profits themselves do so.
But independent changes in monetary policy will ultimately be reflected in inflation and, despite a decline in interest rates that’s now gone on for 20 years, inflation has remained pretty close to target, throughout the developed world (Chart 1). This suggests that, rather than causing the decline themselves, central banks have instead been accommodating a deeper downward trend in the “natural” or “equilibrium” rate of interest. That is not a trivial matter: if they had failed to track this trend, policy would have been too tight and inflation and output too low. And although stocks performed well through the early part of that decline, for much of it they’ve not done so. Chart 2 plots the yield – inversely related to the price – on indexed gilts and UK equities. Through the 1990s these two markets tended to move together and, in price terms, generally upwards. Since around 2001, however, their yields have diverged. Equities have significantly underperformed bonds. This suggests that, over that past decade or so, the forces depressing the natural rate of interest have also been increasing the extra premium required of risky assets. What I want to do today is say something about the causes of these trends and (in only the broadest possible terms) their implications for the distribution of wealth and income. None of this will be particularly novel.