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Recent Rise in Real Interest Rates Could Jeopardize US Economic Recovery

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Low real yields accompanied by sufficient nominal growth are the necessary prescription for a still-ailing economy.

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Since the end of March, 10-year real yields, as measured by US Treasury Inflation-Protected Securities (TIPS), have risen from deeply negative territory to around 0.1%. Real interest rates can rise for one of three reasons: the creditworthiness of a country is worsening, economic growth is improving, or inflation expectations are falling. Standard & Poor's just revised its credit outlook on the US government to stable from negative, so we can rule out the first reason. And while we would welcome the second reason, my firm believes the rise in real yields had more to do with a drop in inflation expectations. Indeed, 10-year inflation expectations, as measured by the difference between nominal and real yields, fell from 2.52% at the end of March to around 2.05% now.

We think this rise in real rates and fall in inflation expectations could jeopardize the few glimmers of strength in the US economy, particularly the nascent housing recovery. We also think they are a direct result of uncertainty about the Federal Reserve's ultimate goal.

One of the arguments of PIMCO's "New Normal" view is that excessive debt and leverage need to be dealt with before private demand accelerates enough to generate economic growth without assistance from the monetary or fiscal authorities. Low real yields accompanied by sufficient nominal growth (though real growth would be better) are the necessary prescription for a still ailing economy.

Housing Prices Are Sensitive to Real Rates

One reason to be concerned about the recent rise in real yields comes from the potential impact on the housing market and its spillover. Real mortgage rates are 100 basis points higher now than they were at the end of the year (see Figure 1).



Higher house prices help the deleveraging process and boost consumption, and housing has been a job-intensive sector with large spillovers into the real economy. But house prices are very sensitive to real rates, even more than to nominal rates. House prices benefit from lower real yields and higher inflation expectations, which feed into higher rents. As a result, owning a home is more attractive if you anticipate inflation and rents to move up. Conversely, if you are worried about deflation, then it makes more sense to hang on to your cash and rent. The Fed has been trying to push investors and consumers out of cash through repressed real yields. But when real yields rise too soon, it threatens to erase the progress the housing market has made so far.

Higher Inflation Expectations Are Part of the Solution, Not the Problem

The 2008 recession brought the US economy into a liquidity trap. Excessive debt and the largest economic contraction in the country since World War II forced the Fed to push interest rates all the way to their zero lower bound. When you hit the zero bound for nominal interest rates, the only way to increase monetary accommodation by lowering real interest rates is to increase inflation expectations.

Central bankers should be eager to leave the zero bound as quickly as possible. To do so, they need to bring the nominal GDP back to where it was before the crisis. Until then, debt ratios will remain elevated and real demand will be anemic because of the ongoing deleveraging. Hitting the zero bound is costly and has happened too often because nominal interest rates and inflation expectations were too low to begin with.

At the zero nominal interest rate bound, the Fed should be asymmetric and prefer inflation to be well above target rather than below. This would help the economy escape the liquidity trap, allowing nominal rates to ultimately normalize and rise.
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