ECB not to blame for low yields

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Willem Verhagen (pictured), senior economist at NN Investment Partners (NN IP) argues that not only is the ECB not to blame for record low bond yields, it should also play a key role in the recovery of bond market yields. 

Safe Treasury yields in Euroland have fallen to extremely low levels. The big questions facing investors is who or what is responsible for this and whether or not we will ever see “normal” (i.e. pre-crisis range) bond yield levels again. Some pundits argue that the ECB is to blame. In our view this is simultaneously correct and wrong. It is true that the ECB is pushing yields lower but the central bank is doing so because it has no choice. The ECB’s hands are forced by forces in the real economy.

To understand this let us go back to basics. The nominal yield we observe in the market everyday can be decomposed into a real yield and expected inflation. The real yield,  in turn, is determined by monetary factors (the expected future path of the policy rate) as well as real ones (the term premium which is driven by savings and investment appetite as well as the degree of risk aversion). However, this does not hold for its unobservable twin sister the neutral real rate. The latter is defined as the real rate consistent with full employment. In a theoretical world where there is no money real yields would always be equal their neutral value.  In the real world the very existence of money can thus drive a wedge between them, at least in the short to medium term.

If the real yield is below its neutral level growth will tend to accelerate which may eventually cause a pick-up in inflation momentum. Also, credit flows and asset prices will embark on an upward sloping path. These trends will reverse if the real yield is above neutral. Because the main job of the central bank is to ensure macro stability it immediately follows that it will seek to set the actual real rate equal to neutral on average in the long run. Otherwise, the economy would embark on an unstable explosive path causing the central banker to lose his job.

Shocks to the neutral real rate (e.g. to savings and investment appetite, risk aversion etc.) happen all the time and push this animal around. Because of recognition and implementation lags monetary policy will never perfectly react to this which is an important reason why we observe a business cycle. A particularly big shock occurred in DM space in 2008 which pushed the neutral real rate deeply into negative territory. Because of the zero lower bound on the policy rate, actual real rates could not follow. In a nutshell this explains the sluggish growth performance in the years after that.

The essence of all DM central bank action since then can be seen as an effort to achieve two things. First of all, they aimed to drive nominal rates lower to close the gap between actual and neutral real rates. Secondly, in doing so they hoped to restore private sector confidence that the central bank will attain its price stability and full employment goals. If successful the latter will have two effects: It will increase inflation expectations and thus drive actual real yields lower. In addition to this, improved nominal growth expectations will reduce savings appetite and improve investment intentions as well as risk appetite. In doing so higher expected nominal growth will thus increase the neutral real rate. Eventually, these developments will be reflected in the real rates we observe as well via a rising term premium as capital becomes more scarce and investors substitute towards risky assets in their portfolios

The upshot of this story is thus very simple: In order to increase the chances of a return of bond yields to pre-crisis ranges in the longer run (via a higher neutral real rate and higher expected inflation), the central bank must push nominal bond yields extremely low in the present. Once this is done sufficiently the economy will embark on a self-fulfilling upward trend where the neutral real rate will gradually rise.  At some point the actual real rate will then follow at first via a rising term premium and later also via a steepening of the expected path of future policy rates. There are of course other ways to push the neutral real rate higher and make monetary policy more effective. One option is a fiscal expansion which can be seen as a reduction of overall domestic savings appetite. Alas in Euroland this route is blocked for legal reasons. As a result most of our hopes of seeing normality again rest on the ECB.

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