Understanding the interest-rate growth differential: its importance in long-term debt projections and for policy

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1 Understanding the interest-rate growth differential: its importance in long-term debt projections and for policy David Turner, OECD UN DESA Expert Group Meeting on the World Economy, LINK Project October 24-26, 2011, New York

2 In long-term, fiscal problems not confined to euro area! 300 Gross government debt projections under a stylised and gradual fiscal consolidation rule (% of GDP) 250 USA Japan Euro area Δd = pb + (r g) d 1 (+sf) where d = debt to GDP ratio pb = primary balance ratio r = effective interest rate on net debt g = nominal GDP growth sf = stock flow adjustment Source: OECD Economic Outlook, May 2011, chapter 4.

3 It matters a lot in the long-term : Small changes in (r-g) have large effects on debt projections 140 US gross government debt projections under differnt assumptions about (r g) differential Baseline (r g) less 1% pt 40 (r g) less 2% pt N.B. Likely to understate differences if additional effect from lower fiscal risk premia.

4 Pre-crisis (r-g) differential in 2000s was much lower than over 1980s and 1990s. Where next? 7.0 Interest rate growth differential for 23 OECD countries Median 4.0 Lower quartile Upper quartile The 23 OECD countries have been chosen for consistent time series estimates for potential output and long-term interest rates on 10-year government bonds from Using nominal potential growth instead of actual GDP growth abstracts from the cycle and so gives a better impression of trend movements.

5 Why was the pre-crisis differential so low? Alternative, but not mutually exclusive, explanations Lower and less volatile inflation Policy rates kept too low for too long Under-pricing of risk The global savings glut Understanding reasons for historical variation is important not only to project future, but also to understand how it might respond to policy.

6 Lower and less volatile inflation Level and volatility of OECD inflation has fallen OECD inflation (GDP deflator) 5 year Standard deviation Support from empirical studies (eg Wright, AER 2011) & event study of Bank of England independence. Medium & long-term implications If central bank credibility locked in then should imply a permanent long-term fall in (r-g) differential But also implies substantial risks from trying to inflate away debt (see also Box 1.8, OECD Economic Outlook, May 2011)

7 (Too?) Low policy rates 2 Differential between OECD aggregate short rates (3 month) and long rates (10 year) Medium & long-term implications 1 0 Policy rates likely to remain low for many years, but will eventually normalise 1 2 Short rates unusually low for an unusually long => Reversion to higher (r-g) differential as output gaps close 3 4

8 Risk aversion has increased 8.0 (r g) differential for euro countries under financial pressure Medium & long-term implications GRC IRL ITA PRT ESP Average Average Financial crisis and new capital requirements have increased risk aversion Clear illustration for euro area countries currently under pressure Financial markets more discriminating about sovereign debt risk. How much time do USA and Japan have?

9 The global savings glut Current Ac surplus of China and non OECD oil exporters as % of world GDP Bernanke (2005 & 2011) Medium & long-term implications Will not disappear quickly, but may fade away over longer-term as Asian population ages, greater provision of social spending, etc

10 Some simple econometrics to try to discriminate between explanations Panel regression, G7 countries, , country fixed effects, Dependent variable (r- g) where r is 10-year govt bond rate and g is growth rate of nominal potential GDP All effects statistically significant and correctly signed. Variable Coefficient t-ratio Long-run Inflation variability (5 year standard deviation of inflation) Slope Yield curve(-1) (short minus long rates) Lagged dependent variable

11 ..and some support for global savings glut Panel regression, G7 countries, , country fixed effects, Dependent variable (r- g) where r is 10-year govt bond rate and g is growth rate of nominal potential GDP. Variable Coeff. t-ratio Long-run Inflation variability (5 year standard deviation of inflation) Slope Yield curve(-1) (short minus long rates) Lagged dependent variable Current Ac surplus, China + non-oecd oil exporters (as % world GDP)

12 Explaining the average fall in (r-g) These equations can be used to explain the unweighted simple average fall in (r-g) differential between and Explanatory Variable Simple eqn Extended eqn Average fall in (r-g) Inflation variability (5 year standard deviation of inflation) Slope Yield curve(-1) (short minus long rates) Current Ac surplus, China + non-oecd oil exporters (as % world GDP)

13 Conclusions (1) As policy rates normalise and quantitative easing ends, likely (r-g) will rise as output gaps close. Lower and less volatile inflation in 2000s reduced (r-g) by more than 2% pts relative to 1980s & 90s, should be permanent if central banks remain credible, but this implies risk of substantial cost from trying to inflate debt problems away.

14 Conclusions (2) Also some evidence that a part of fall in (r-g) in 2000s is unexplained & so could reappear. Experience from euro area that financial markets are now more discriminating about risk. Over long-term, countries that are vulnerable include USA and Japan, especially because neither yet has a credible medium-term plan to reduce debt To extent that global savings glut is a factor need a global model capable of projecting long-term global savings & investment balances. Watch this space!

15 Understanding the interest-rate growth differential: its importance in long-term debt projections and for policy David Turner, OECD UN DESA Expert Group Meeting on the World Economy, LINK Project October 24-26, 2011, New York

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