Have we seen the end of cheap money?

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We are seeing the beginning of an easing cycle in monetary policy. Many now ask how far might interest rates fall and what those falls might mean for our economies. Yet, for me, the more interesting questions are longer-term. To be precise, there are three. First, have real interest rates at last made an enduring upward jump, after their secular decline to extraordinarily low levels? Second, has the valuation of stock markets ceased to be mean-reverting, even in the US, where mean-reversion had long seemed the norm? Third, might the answer to the first question have any bearing on the answer to the second?

In answering the first, we have one invaluable piece of information — a direct estimate of real interest rates for the UK provided by 10-year index-linked gilts for just under 40 years. US Treasury inflation-protected securities provide comparable information for the US, but only since 2003. These match each other well between 2002 and 2013. Since then real rates have fallen notably lower in the UK than in the US. The explanation must be the regulation of UK defined benefit pension plans, which has forced them to fund the government at absurdly low real interest rates, at great cost to the economy.

Between their peak in September 1992 and their trough in December 2021, UK real rates fell by more than eight percentage points. In the US, they fell by more than four percentage points between their peak in November 2008, at the beginning of the financial crisis, and December 2021, after the pandemic.

Two things happened: a long-term decline in real interest rates and then a sharp fall triggered by the global financial crisis and the pandemic. The longer-term decline must in large part reflect the impact of globalisation, notably China’s huge excess savings.

Yet the recent rise in real rates has not brought real interest rates back to pre-financial crisis levels: today, they are 1.5 per cent in the US. These are modest rates. Estimates by the Federal Reserve Bank of St Louis (using a different methodology) give real interest rates of above 2 per cent in the 1990s in the US.

We have some reasons to expect real rates to go even higher. After all, they are still not all that high. Fiscal positions are stretched, notably in the US. There are the investment needs of the energy transition to fund, too. We have also moved from ageing to aged societies. This will tend to lower savings and raise fiscal pressures in high-income countries and China. Global turmoil will also raise spending on defence. This suggests that further increases in real rates are plausible. At the same time, ageing societies will tend to spend less on consumer durables and housing. This would weaken demand for investment. Moreover, as the OECD interim Economic Outlook notes, global economic growth is not widely expected to pick up strongly.

On balance, it is hard to have a strong view on future real interest rates, in either direction. Yet one might still have a view that inflation is set to return, perhaps as a result of soaring fiscal deficits and debts. That would show up as higher nominal interest rates if (or when) confidence in the ability of central banks to hit inflation targets started to erode. They have contained the recent price upsurge. But inflationary pressures could very easily return.

Now consider equity prices. What have today’s higher real interest rates meant for them? So far, the answer is: very little. If we look at the cyclically adjusted price-earnings ratios (Cape) developed by the Nobel-laureate Robert Shiller, we find that in the US both of the ratios he currently uses are close to all-time highs. The implied cyclically adjusted earnings yield on the S&P 500 is a mere 2.8 per cent. That is just one percentage point above the Tips rate. It is also much lower than for any other significant stock market.

“Sell”, it seems to scream. Needless to say, that has not been happening. So, why not? Today’s earnings yield is, after all, almost 60 per cent below its historic average. One answer, lucidly propounded by Aswath Damodaran of the Stern School of Business, is that the past is not relevant. Certainly, he is right that backward-looking valuation ratios have been a poor guide to future returns, at least since the financial crisis. We cannot know whether this will remain true. Yet it is not hard to understand why he has jettisoned the past in favour of forecasts of future earnings. But the future is also highly uncertain. It is not difficult to imagine shocks able to disrupt markets that are far worse than the recent ones.

What we do know is that the margin between the real interest rate and the cyclically adjusted earnings yield is very small. It seem safe to argue that prospective returns from owning US stocks are unlikely to come to any large extent (if at all) from revaluations, given how highly valued they already are. Even the current valuations must depend on a belief in the ability of earnings to grow at extremely high rates far into the future, perhaps because existing (or prospective) monopolists will remain as profitable as today’s tech giants (now including Nvidia) have been.

This is essentially a bet on the ability of today’s US capitalism to generate supernormal profits forever. The weakness of other markets is a bet on the opposite outcome. If investors are right, recent rises in real interest rates are neither here nor there. In sum, they are betting on the proposition that “it really is different this time”. Personally, I find this hard to accept. But maybe, network effects and zero marginal costs have turned profitability into “manna from heaven”. Those able to collect it will enjoy their feast of profits forever.

Real interest rates? Who cares? Soaring inflation might be another matter.

martin.wolf@ft.com

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