What message should we take from negative real interest rates?
If you’re worried about inflation, one investment you might consider is an inflation protected security from the U.S. Treasury, such as the 4-1/2 year TIPS just issued. For a $1,000 investment, the Treasury will make a $2.50 coupon payment to you twice a year (or a 0.5% annual rate), and give you your $1,000 back in April 2015. If the headline CPI goes up between now and then, both the coupon and principal will go up by exactly the amount of inflation. And if there is deflation, you still get the $2.50 coupon and $1,000 principal back without penalty.
Doesn’t sound like much? Well, it looked good enough to investors that they just bought $10 billion worth of that security, paying $1,050 for each $1,000 par value. At that price, if there’s no inflation, they lent more to the government than they’re ever going to get back in coupons and principal over the entire life of the bond. That works out to a negative yield to maturity on the bond of about -0.5% if there’s no inflation over the next 5 years.
But what else are you going to do? You could buy a 5-year note without inflation protection offering a nominal yield of 1.2% per year. But if you expect, say, 2% inflation per year over the next 5 years, in real terms you’d lose even more money on the nominal security than you would on the TIPS.
Although this appears to be the first time that newly issued TIPS have locked in a negative real return, that’s because TIPS have only been offered to U.S. investors since 1997. You can get a longer time series by comparing the yield on a 6-month T-bill at any date with what the CPI inflation rate actually turned out to be over the subsequent 6 months for which investors held that bill, a magnitude sometimes described as the “ex-post real interest rate.” That series is plotted below. We’ve actually been in a period for several years in which short-term loans to the government were a losing proposition in real terms, and the longer-term real yields such as the 5-year TIPS are only now coming down to join them. The recent era of negative real yields was briefly (if spectacularly) interrupted in the fall of 2008, when a sharp deflation in the CPI made short-term loans to the government an excellent deal for the lender in ex-post real terms.
Negative ex-post real rates on short-term securities are thus nothing new. We saw them for much of this decade and for much of the 1970s. Although negative realized ex-post real rates do not establish that investors knew that they were in for a losing bargain in real terms, they persisted long enough in the 1970s that it’s hard to believe that people were shocked by the continually repeated outcome. I think if TIPS had been offered at that time, we would have seen a negative real yield then, too.
What does a negative real rate signify? If you consider a simple one-good economy in which the output is costlessly storable, a negative real rate could never happen– people would simply hoard the good rather than buy such miserable assets. You’re better off storing a can of tuna for a year than messing with T-bills at the moment. But there’s only so much tuna you can use, and many expenditures you might want to save for can’t really be stored in your closet for the next year. It’s perfectly plausible from the point of view of more realistic economic models that we could see negative real interest rates, at least for a while.
Even so, within those models, there’s an incentive to buy and hold those goods that are storable. And in terms of the historical experience, episodes of negative real interest rates have usually been associated with rapidly rising commodity prices.
In terms of the Fed’s policy objectives at the moment, one of the problems with deflation is that it guarantees a positive real return just from stuffing cash under your mattress. A primary purpose of the Fed’s contemplated QE2 is to prevent this and spur consumers and firms to invest funds productively rather than hoard cash. Insofar as the recent moves in TIPS and other yields represent the market already pricing in the Fed’s next steps, one might conclude from the latest TIPS readings that this aspect of the Fed’s strategy is already working.
And that makes it a good time to bring up again the point that we should not expect too much from QE2. The Fed can help, but it’s not going to solve all our problems. I earlier guessed that the market has already priced in another trillion dollars in long-term asset purchases by the Fed. I recommend that the Fed go through with that, but keep a watchful eye on real rates and commodity prices before attempting any more than that.