When Are Interest Rates Expected To Normalize?

Includes: TIP
by: Brad DeLong

Paul Krugman:

Meanwhile, In The Bond Market: The real interest rate on 10-year US bonds is now firmly negative. This is as clear a demonstration as you can ever expect to see that the models some allegedly authoritative figures use to analyze the economy are dead wrong; it’s also an indication that obsessing over the deficit, and actually cutting back sharply on government investment, are crazy.

FRED Graph  St Louis Fed 2

It's not just that we are in a liquidity trap, with short-term Treasury rates effectively at zero and short-term Treasury bonds perfect substitutes for or dominated by cash. It's that we are expected to remain in a liquidity trap for a long time to come.

A normalization of the 10-year TIPS rate--a return of the 10-Year TIPS yield to 2%/year--would produce an instant 20% loss to holders of TIPS. Yet TIPS holders find options in other asset classes so unattractive that they are willing to run that risk and pay the U.S. Treasury 0.25%/year in real terms for the privilege of running that risk.

That is a very powerful statement of how low market tolerance for risk and how pessimistic market expectations of continued profits are.

If the option is simply holding cash--which it appears to be--then the liquidity trap has, if normalization is the alternative, a risk-neutral probability measure expected lifetime of ten years: just one chance in ten that we will see normalization next year, and a 37% chance that we will still be in this liquidity trap a decade hence with the same outlook relative to potential we have now.

Now continued liquidity trap and full normalization aren't the only states the economy can be in, and RNPMs aren't probabilities (they are probabilities multiplied by swing investor relative marginal utilities and scaled to sum to one).

And we certainly hope that the bond market is irrationally depressed.

But I must say I never expected to see anything like this in a fiat-money managed-currency world. Yes, I knew that under a gold standard things like this could happen: that by itself was sufficient reason to drop the gold standard. But I never imagined that central bankers claiming to be technocrats would wedge the economy here, and then refuse to take the actions they could take to get us out, and that fiscal authorities would similarly shy at the jump, and that banking and housing regulators would sit on their hands as well…