Is the real policy rate below zero?

The real policy rate has risen markedly since mid-year and is now positive by most of the measures that matter. Indexed interest rates have risen in Iceland and abroad in the recent term and are higher than they have been in years. This indicates that the monetary stance is probably appropriate for the next few quarters, even if the nominal policy rate is not raised further.


It is sometimes asserted these days, both verbally and in writing, that the real rate is still low – and even negative – despite the Central Bank’s (CBI) nominal rate hikes. But is this truly the case? To put it succinctly, this depends on how the real rate is measured, but in our estimation, the answer is generally no.

When the pandemic opened fire with both barrels, the CBI cut its nominal policy rate rapidly, as did other central banks worldwide. The purpose of this aggressive monetary easing was to push the real rate downwards and use the resulting slack to cushion against the pandemic-related economic shock to the extent possible. These efforts were successful, and the real policy rate was consistently negative by all measures from Q2/2020 until well into this year.

As inflation has risen and the economy has bounced back, the CBI has raised the policy rate in a bid to curb inflation – again using the real rate as a benchmark. But this part proved easier said than done, and the real policy rate remained negative by all key measures until well past the middle of this year. In recent months, however, the real policy rate has risen swiftly by various measures and is now positive by most of them.

As the chart shows, two measures of recent developments in the real policy rate stand out somewhat: the real rate in terms of households’ inflation expectations and the real rate in terms of measured inflation. But here it is important to remember that household expectations correlate strongly with observed inflation at any given time and therefore have limited predictive power vis-à-vis future inflation.

However, the measure that is most often cited – and yields the lowest real policy rate – is the one that has the least significance: the comparison of the nominal policy rate and measured twelve-month inflation. Twelve-month inflation is now 9.3% – more than 3% above the CBI’s 6% nominal policy rate.

Naturally, near-term expectations are affected when inflation is as high as it has been recently, and households’ inflation expectations affect wage demands, spending patterns, saving behaviour, and more besides.

But there is little to be gained by comparing interest, which naturally delivers future returns, and inflation measurements, which are backward-looking and reflect the rise in the consumer price index over the previous twelve months. For savers and investors, the primary concern is whether interest rates keep pace with the rise in the price level over the term of their investment. By the same token, the real cost of borrowing depends on whether interest expense is greater or less than the rise in the price level over the loan term.

This difference becomes particularly clear when the outlook is for a relatively rapid decline in inflation, as is generally expected now according to most expectations metrics, the breakeven inflation rate in the bond market, and inflation forecasts.

Here is an example. We forecast that the nominal policy rate will be 6% until mid-2023 and then be lowered to 5.5% by end-2023. According to this forecast, the policy rate will average 5.8% over the next twelve months, with returns right around 6% after factoring in compound interest. For 2023, we forecast inflation over the year – i.e., twelve-month inflation in December 2023 – at 4.8%. By that measure, the real policy rate will be just over 1%.

Indexed interest rates on the rise

The real rate that matters for households, businesses, and the public sector is almost always the fixed indexed rate over a term of several years, whether applied to financing costs or returns on savings. This rate has developed broadly in line with the real policy rate. For example, indexed Treasury bond yields fell to a trough in late summer 2020, actually turning negative for some bond series. They have risen markedly since this past spring, however, and are now around 1.9%. Indexed base interest rates by this measure are roughly at the mid-2018 level.

This phenomenon is not unique to Iceland, although indexed interest rates do play a larger role in the Icelandic financing markets than they do in most foreign countries. As the chart indicates, the yield on US TIPS Treasury bonds, for instance, is similar to the yield on Iceland’s RIKS Treasury bonds. Real yields on most indexed bonds issued by the UK and German governments, on the other hand, are close to zero after being negative for most of the past decade. In the last two cases, the lower rate on indexed government bonds reflects expectations of lower real policy rates in those countries, which in turn reflects greater pessimism about the economic outlook than is generally found, for example, in the US or Iceland.

In other words, the real rate in the economy has risen quite a bit in 2022, and looks set to be higher by most, if not all, measures than it has been in recent years. The monetary stance is therefore relatively tight at present, and all else being equal, we think the current stance will probably suffice to bring about a better balanced economy and put the brakes on inflation further ahead, obviating the need for further nominal policy rate hikes by the CBI.

Analyst


Jón Bjarki Bentsson

Chief economist


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