Steve Ambler is the David Dodge Chair in Monetary Policy at the C.D. Howe Institute, and professor of economics at the University of Quebec. Jeremy Kronick is associate director, research, C.D. Howe Institute.
As expected, the Bank of Canada held its overnight rate target constant at 1.75 per cent this week.
More unexpectedly, with the release of its latest Monetary Policy Report, the central bank lowered its estimate of the neutral nominal rate – the rate compatible with full-capacity output and inflation equal to the 2-per-cent target – to 2.25 per cent to 3.25 per cent, from 2.5 per cent to 3.5 per cent. This means that the constant overnight target rate is closer to the neutral rate than previously thought, providing less stimulus to the economy. As the lower end of the range gets closer to 2 per cent, meaning the real neutral rate would be zero, it is fair to ask how much lower the neutral rate can go.
From a data perspective, three primary factors affect the neutral rate: trend, or longer-term, productivity growth; demographics; and global factors affecting interest rates. Driving the shift down in Canada’s neutral-rate range this time was a shift down in the global neutral rate.
With the lower end of the range now 2.25 per cent, we are staring at the reality of a real neutral rate near (or at) zero. With demographics likely worsening, and trend productivity growth showing little signs of rebounding, could a negative real neutral rate really be possible? For investors, that could mean negative returns after inflation is taken into account.
This would be somewhat difficult to reconcile with standard economic theory, which says that in the very long run, the real rate of interest must be positive. Individuals are fundamentally impatient and will only give up a dollar of goods today if they are promised more than a dollar of goods tomorrow; that is, get a return on their investment. In the short-run, individuals might make this sacrifice, but not over a longer horizon.
However, economic theory does provide an out: It can take a long time to get to that long run, and until then, uncertainty prevails. But is anything likely to change as we look ahead?
Start with demographics. Many countries, including Canada, have undergone dramatic demographic transitions, and the effects of these transitions are still working their way through the system. Longevity has been increasing at a faster-than-expected pace, and many households have discovered that their savings are insufficient to meet their expected needs in retirement, leading to higher savings rates. The equilibrium real interest rate equalizes savings to investment (on a global scale). An increase in savings drives the equilibrium rate down. As households age, their demand for safer assets increases, driving up the price of these assets and driving down their rate of return.
Other pressures are also weighing on rates. Many of the world’s central banks, including the Federal Reserve in the United States and the European Central Bank, have dramatically expanded their balance sheets by holding a larger amount of safe assets, leading some to conclude that there is a severe safe-asset shortage in the world economy, causing lower real rates of return on those assets. Finally, growth has been sluggish since the financial crisis, and lower real growth also leads to lower real interest rates in standard economic theory.
What about trend – or longer-term – growth? In Canada, unfortunately, trend growth has declined dramatically over the past 30 years. One estimate has it halving to 1.5 per cent today from 3 per cent in 1990, largely driven by falls in both the early 1990s recession and the 2008-09 financial crisis. Worse, with the exception of a brief period before the dot-com bust, there have been few periods where it has increased.
It is not the job of monetary policy to affect demographic change or long-run real growth. However, central bankers must use the information at hand to determine how to conduct monetary policy. With the current target rate perhaps as little as 50 basis points or less away from the neutral rate, and with very few signs of upward pressure on headline inflation, the bank will likely remain on the sidelines for the foreseeable future. Also, with a neutral real rate approaching zero, more than two percentage points lower than before the financial crisis, the bank’s inflation targeting framework is clearly in uncharted territory.