History lessons

One thing that grabs my attention is historical evidence of repeating patterns of economic behaviour. Such patterns don’t improve the accuracy of economic forecasts, but they can be informative in terms of taking bearings as to what point in the cycle has been reached, and the likely future direction and speed of travel.

This post looks at interest rates, particularly ‘real’ rates, i.e. the rate of interest minus the rate of inflation. This rate is a vital ‘moving part’ in capitalist economies, and a key driver in valuing capital assets (as a discounted multiple of future income streams) relative to a so-called risk-free alternative.

Put simply, other things being equal, a rise in (real) interest rates reduces capital values, and vice versa. The longer the period over which the capital asset is expected to produce an income, the bigger the impact of even a small change in interest rates. There is a close analogy here with the discount rate used in assessing lump sum damages for personal injury: reducing the discount rate increases the lump sum, and increasing the discount rate (a real rate) reduces the lump sum. The only part that moves here is the (real) interest rate: the underlying cash flows remain the same.

Investors therefore need to pay attention to the current (real) rate of interest, and have a view about expected changes.

The consensus view, reinforced by the official line of the Bank of England, is that interest rates will remain ‘lower for longer’. A guest post by historian Paul Schmelzing published on the Bank’s unofficial blog, Bank Underground, challenges that view with historical evidence on real interest rates since 1311.

Schmelzing identifies nine ‘real rate depressions’, i.e. extended periods of stagnant/negative real rates, lasting between roughly 10 and 60 years. Just in case you have not noticed, we are in one right now. It started in 1984!

Schmelzing makes some interesting observations, but the key one for this post is that there is solid historical evidence that, once rates turn, real rates rise a lot more quickly than might be expected.

Investors ignore this history lesson at their peril!