Wednesday, March 5, 2014

Global interest rates and growth (r-g).

The difference between interest rate and growth rates appears as an important parameter in many macroeconomic models. It is also a key variable to assess the sustainability of public finances: higher interest rates make the cost of carrying over debt higher while high growth rates help keep the debt to GDP ratio under control.

In a recent post Floyd Norris criticizes the assumptions used by the US Congressional Budget Office for its fiscal projections because they are assuming lower growth rates ahead but a return to "normal" interest rates. The point that Norris makes is that we tend to think that interest rates and growth rates are correlated, so if growth is going to be much lower going forward we should also forecast lower interest rates (and this will make the fiscal outlook look more positive).

Paul Krugman initially supports Floyd Norris' arguments but later, after checking the data, he realizes that growth and interest rates are not that correlated. Here is the picture of the difference between interest rates and growth rates for the US (from Krugman).

The relationship between interest rates and growth rates shows no clear pattern in the chart. During the 60s interest rates were lower than growth rates (when growth was high). We see a similar pattern in recent years but in this case growth is low. The 80s stand out as a period of high interest rates compared to growth (and growth was around its long-term average).

But there is an additional issue regarding the difference between this analysis of interest rates and growth: Norris and Krugman are looking at interest rates and growth in the context of one economy (the US). But given the global nature of capital markets the relationship between interest rates and growth (if any) should only be present at the global level. What happens if we look at the  differential between interest rates and growth for the world? Here is a quick attempt to measure this difference:

[See footnote for data sources and calculations]

To understand better how the pattern above matches that of GDP growth, here is World growth in each of these decades (measured both in real terms -constant US dollars- and nominal terms - current US dollars).

What is the World pattern of growth and interest rates? As in the US data, the relationship between interest rates and growth rates has varied over the past decades. Real growth is stable across all decades although increasing after 2000 (because of emerging markets).

The 80s stands out as a decade with very high interest rates relative to growth. The 2000s and the 2010-13 period are characterized by very low rates relative to growth (while global growth remains strong).

What determines interest rates then? The usual narrative of the post 2000 sample is that of the saving glut that stars in the late-90s with the increase in saving rates in regions like Asia (partly as a response to the Asian crisis). Theoretically, such a global shift in saving should lead to lower interest rates and increasing growth rate in the world.

In summary, given that interest rates are determined by global conditions, anything could happen when comparing them to growth rates for a given country (of course if the country is large enough to influence global variables then national and global conditions are correlated). The right way to look at these two variables is at the world level. But the empirical evidence confirms that, even if we look at a global level, one cannot rule out future scenarios of movements in interest rates and growth rates in opposite directions (they still need to be justified in terms of the global dynamics of investment and saving, but they are possible).

Antonio Fatás

[Some data issues: World GDP is coming from the IMF World Economic Outlook (converted to USD using market exchange rates; using PPP does not make a difference). I have taken the average of interest rates and growth rates over a decade (each of these decades includes some global recession so cyclical factors might not matter much except for the 2010-2013 period). Unfortunately data starts in the 80s so I cannot say much about the 60s and 70s (yet). Interest rates are from US treasuries under the assumption that this is the closest we can get to a World interest rates on riskless assets (using interest rates from other advanced economies will not change the pattern much; using interest rates from emerging markets can make some of a difference because of the volatility of risk premia). I have done the calculation using both a 10-year and a 1-year bond -- as it is clearly from the chart, the overall pattern is similar.]