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May's market tremors could reflect fear of 'groupthink'

Federal Reserve Chair Janet Yellen speaks at a meeting of the Financial Stability Oversight Council (FSOC) at the Treasury Department in Washington May 19, 2015. REUTERS/Carlos Barria

By Mike Dolan

LONDON (Reuters) - For anyone expecting interest rates to be stuck near zero for years to come, the past month has been uncomfortable.

The so-called "new normal" or "secular stagnation" theses that posit years of paltry world growth, lingering economic slack and downward pressure on prices and interest rates have fast become consensus thinking among top investors, financial and academic economists.

So much so that policymakers and markets have shifted dramatically to discount them, pushing official and long-term interest rates to zero and below - spooked late last year by the deflationary threat associated with a halving of oil prices.

And while consensus thinking has become consensus policymaking, the financial herd has followed suit.

But some fear that 'groupthink' may have taken hold on a problem that's not all black and white.

This month's jolt higher in long-term borrowing rates around the world reflects some of those doubts, as much as angst about overstretch in the bond market combined with ebbing fears of chronic deflation, rebounding commodities and the euro zone's return to growth in the first quarter.

Investors watching a jarring, weather-related U.S. economic stutter over that same period were especially blindsided given many had started to push the Federal Reserve's long-awaited first rate rise in nine years onto the back burner and even into 2016.

They received another reality check last week as U.S. April inflation surprised, Fed chair Janet Yellen stuck to her guns on a 2015 hike and her Vice Chair Stanley Fischer emphasized a Fed rates horizon as high as 3.25-4 percent through 2018.

So some ask if the sub-par, slow-mo, non-inflationary global growth assumption and its longevity have been overstated?

Morgan Stanley economist Manoj Pradhan says former U.S. Treasury Secretary Larry Summers' reprise of Alvin Hansen's 1938 thesis that the economy is heading for many years of secular stagnation has been a "spectacular success" in capturing the attention of central bankers, governments and investors.

The gist of Summers' argument is that the world is operating far below capacity but a huge excess of savings - in part driven by the aging of Western populations - means the real interest rate required to eat up that slack could well be deeply negative.

As that makes it so difficult to get today's real interest rates below that 'equilibrium', due to the 'zero bound' on rates and persistently low wage and inflation rates, then the output gap and slow growth will have to persist for much longer.

Given that some 27 central banks having eased monetary policy this year, cutting interest rates in some cases below zero or by buying bonds that pushed many longer term rates negative in Europe, it's not difficult to see how quickly reality has followed theory.

"The world economy effectively has a sizeable negative output gap; extremely accommodative monetary policy is required to close it, particularly when fiscal policy is either tightening or neutral in most of the large economies," fund manager Standard Life Investments told clients this week.


But Morgan Stanley's Pradhan critiques Summers by contrasting 'secular stagnation' against two other influential theories aiming to explain the sub par world expansion since the financial crash of 2007/2008.

Harvard professor Ken Rogoff's 'deleveraging' view agrees the economy is performing below potential but insists the problem is one of excessive debt and once that debt is paid down the gap can be closed. Actual household and corporate borrowing rates, rather than official policy rates, may still be just too high and the equilibrium real rate may not have fallen by much.

US economist Robert Gordon's 'headwinds' view, on the other hand, reckons demographics, inequality and debt have all combined to cut potential growth to where it is now, no significant output gap exists but the drag will persist for years. For him, equilibrium rates are just where they are now.

While the three can't all be correct at the same time, it's reasonable to think that some elements of the other two mean 'secular stagnation' has some caveats at least. And if so, purists may well have gone too far.

What's more, Pradhan argues that the sheer success of 'secular stagnation' as a policy influence may well have gone part of the way to solving the problem it is describing.

"By convincing markets and policymakers that secular stagnation is the correct model of the economy, the thesis may have paradoxically lowered real interest rates enough to make secular stagnation less likely," he said.

May's market tremors may have been some echo of that rethink too.

(Editing by Hugh Lawson)