Global real rates: a secular approach

Focus

We propose a simple framework to explain low global real risk-free interest rates. We use a global resource constraint to link real rates with consumption and wealth. This relationship serves as an empirical framework to explain past secular declines of the risk-free rate, as well as to project its future trend.

Contribution

We highlight the importance of the consumption-to-wealth ratio in explaining the real interest rate. Different decompositions of the ratio nest various mechanisms proposed in the literature, such as productivity decline, demographic developments, and deleveraging. The framework enables testing of these hypotheses with few theoretical assumptions. 

Findings

The consumption-to-wealth ratio predicts future movements of the global real risk-free rate. The roaring 1920s and exuberant 2000s were both marked by a rapid decline in the consumption-to-wealth ratio, with both ending in a low rate environment. This experience points to the role of the boom-bust leveraging cycle during the two episodes. Empirical estimates forecast persistently low or negative real global interest rates in the foreseeable future.

Abstract

The current environment is characterized by low real rates and by policy rates close to or at their effective lower bound in all major €nancial areas. We analyze these unusual economic conditions from a secular perspective using data on aggregate consumption, wealth and asset returns. Our present-value approach decomposes fluctuations in the global consumption-to-wealth ratio over long periods of time and show that this ratio anticipates future movements of the global real risk-free rate. Our analysis identifies two historical episodes where the consumption-to-wealth ratio declined rapidly below its historical average: in the roaring 1920s and again in the exuberant 2000s. Each episode was followed by a severe global €financial crisis and depressed real rates for an extended period of time. Our empirical estimates suggest that the world real rate of interest is likely to remain low or negative for an extended period of time.

JEL classification: E21, E43, E40

Keywords: real interest rates, consumption-wealth ratio, financial boom-bust cycle