The Determination of (Real) Interest Rates During the Great Reversal

Abstract

The rising inflation, that Goodhart and Pradhan foresee in the future, will raise nominal interest rates, but not necessarily real interest rates. There are multiple factors influencing the equilibrium real interest rate, r*. Goodhart and Pradhan doubt whether the prospective slowdown in world growth will depress r*. While slower growth will tend to reduce both ex ante saving and ex ante investment in the private sector, the authors tend to believe that savings will fall by more. If so, the public sector should ideally move back towards primary surplus to balance the economy. But rising health and pension costs, and the political unpopularity of tax increases, will hinder that. Political pressures may force Central Banks to hold short-term rates below the level consistent with inflation targets, thus keeping short real rates low, while market pressures lead to stronger increases in long rates, both nominal and real. The yield curve will become much more upwards sloping.