The really, really, long view…

Major central banks have the resources to produce papers that may seem arcane, but also provide an interesting perspective. A recent paper Bank of England Working Paper, entitled “Eight centuries of global real interest rates,

R-G, and the ‘suprasecular’ decline, 1311–2018” is no exception:
‘Suprasecular’ Decline

In it, economist Paul Schmelzing constructed a time series for real interest rates going back some 700 years to 1311. One only has to read the paper to understand the scale of the work undertaken, as well as the fact that there really is not much that is truly new under the (financial) sun. Who knew, for example, that in 1262 (sic) the Venetian Grand Council decreed the establishment of a secondary market in the Serenissima’s long term debt?

Fascinating historical facts aside, what is intriguing about Schmelzing’s work is that it leads him to the conclusion that since the late 1400s there has been a steady decline in real interest rates over the intervening centuries that cuts across asset classes, political systems and monetary regimes. He is careful not to be dogmatic about the precise cause (and the time series is volatile year to year). Capital accumulation and the ability to save more (and expect to be able to enjoy the fruits) are probably the most likely (but in no way definitive) reasons. As a result he posits, in essence, that the “lower for longer” mantra may be rather more than a convenient tag for something hitherto considered to be without much historical context or precedent. In more concrete terms, he suggests that the long term real rate for 2018 would be around 1.50%, which, set against indicative targeted inflation rates of 2% for most major central banks, indicates a nominal cap of around 3.5% for whatever is deemed the safest asset provider- which, of course, has shifted materially over the centuries, heading North West across Europe to the UK and then crossing the Atlantic to the US. In fact, Schmelzing suggests that no-one should be surprised at the current fact of negative nominal interest rates given ultra long term trends.

Of course, this is merely one study. Arguments will doubtless be made that, given what has happened since the GFC to inflation rates and the fact of the piercing of the “zero lower bound”, the author is indulging in the abiding sin of financial modelers and using a backtest (albeit a very long one!) to confirm a desired hypothesis.

However, Schmelzing is studiously careful not state that what is observed has a clear cause (because it does not), but simply points out that the data provide evidence of a secular decline in real interest rates, and that it would be foolish to ignore that point simply because it may be an inconvenient truth.

So far as the (re)insurance industry is concerned, in Awbury’s view it re-emphasizes the need to focus both on the quality of underwriting and on ensuring that nominal investment returns are not used as a “crutch” to mask weak Combined Ratios, while at the same time suggesting that focusing mainly on standard fixed income products to generate those investment returns may also be something that bears re-examination.

The Awbury Team

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