Outlook for interest rates remains uncertain while governments rack up more debt

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Appeared in the Financial Post, March 30, 2023
Outlook for interest rates remains uncertain while governments rack up more debt

As central banks weigh their response to the impact of recent banking calamities including the failure of Silicon Valley Bank and forced sale of Credit Suisse, the outlook for interest rates remains uncertain. Will rates return to pre-pandemic levels as inflation continues to decline? Will they be higher? Lower?

Recently, a virtual debate was held between two renowned economists, Olivier Blanchard, former chief economist of the IMF, and Lawrence Summers, former secretary of the U.S. Treasury, about the fate of “r-star,” the global equilibrium real rate of interest, which serves as the basis for all interest rates.

Among most non-economists, r-star is an unknown or misunderstood concept. In theory, it’s the real (i.e. inflation-adjusted) rate of interest that ensures that the supply of global savings equals the demand for those savings for global investment. Equivalently, it’s the real rate of interest that’s consistent with price and unemployment stability. Because the interest rates we normally observe are nominal—that is, they include the rate of inflation—and are almost never in equilibrium, r-star is unobserved and can only be very roughly approximated. Although Canada’s influence on r-star is very small, it remains a critical variable underlying Canadian monetary policy.

Before the pandemic, estimates of r-star reached a nadir of roughly one-half of one per cent after almost four decades of nearly continuous decline. Why? Possible explanations include higher savings in advanced economies because of longer lifespans and aging baby-boomers and rising wealth and increased savings in some emerging economies (particularly China), and lower investment because of lower productivity and population growth rates. Put simply, the supply of global savings grew faster than the demand for those savings.

Both Blanchard and Summers agreed that r-star was likely to increase over time in the post-pandemic world (although they disagreed by how much) for several reasons including retired baby boomers running down their savings, greater investment demand to reorient global supply chains and restructure economies (notably energy production) in response to climate change, and increased government spending, primarily in advanced economies, on health care, pensions and defence, and subsequent high government borrowing needs.

What are the policy implications of a rising r-star?

First, the good. A rising r-star implies that all interest rates would be higher than otherwise, which means more income for savers but also a higher neutral policy interest rate for central banks. In other words, when inflation returns to the 2 per cent target prevailing in most major jurisdictions, central bank policy rates would be higher than in the recent past. As a result, central banks will have more room to lower rates in the event of an economic downturn making it less likely they’ll need to resort to other more controversial monetary policy tools such as quantitative easing or even negative policy rates to support economic activity.

Next, the bad. The cost to governments of servicing higher debt levels would increase, which means higher taxes or reduced government spending. These changes along with higher interest rates would lead to lower business investment and slower productivity growth and, therefore, to a lower growth trajectory for living standards.

Finally, the ugly—and this is where Blanchard and Summers differed. Blanchard agreed that r-star would rise but remain below “g,” the underlying growth rate of the economy, which is a close proxy for the growth rate of government tax and other revenues. Subsequently, elevated public debt levels would remain sustainable because government tax revenue would generally grow faster than the cost of servicing government debt. Summers, however, felt that the ugly scenario—where r-star is greater than g—was also possible. In this scenario, elevated public debt levels would be on an explosive path, as debt service costs would grow faster than tax revenue. In reaction, government would be forced to raise taxes dramatically and impose severe across-the-board cuts in spending, leading to a major economic downturn, reduced public services (especially for those who need them most) and lower living standards.

Here at home, the Trudeau government tabled its 2023-24 budget on Tuesday, projecting a $40.1 billion deficit this year and sizable deficits for the next four years. By 2028, this will add a projected $131.8 billion in debt to the already record-high debt burden and leave Ottawa’s debt-to-GDP ratio at or above 40 per cent throughout this period. In other words, Finance Minister Chrystia Freeland, who’s been known to seek out Summers for policy advice, failed to heed his warning and exercise the fiscal restraint needed to reduce the likelihood of this ugly scenario in Canada.

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