What is a realistic scenario for a normalization of monetary policy in the US and the EMU? What would be the likely consequences for the stock, bond, and real estate markets?

There is no easy answer to this question. To answer this question appropriately, we first need to define what a “normalization of monetary policy” actually means. In this context, I would interpret it as a turn away from unconventional monetary policies (in particular quantitative easing). These types of policies are employed primarily because the key interest rates of the Federal Reserve and the European Central Bank have been at zero (or even slightly below) for quite some time now. This is referred to as the zero/effective lower bound. To be able to implement conventional monetary policies (i.e. offering an ideal key interest rate), the central banks need room to maneuver in both directions. A return to normal monetary policy goes hand in hand with higher interest rates. But first we need to look at why the interest rate has remained stuck at such low levels and how this affects the markets.

A decrease in real interest rates

One of the key macroeconomic phenomena that we have observed over the last few decades is a decrease in the risk-free real interest rate in the US. This refers to a very short-term interest rate that is free from default risks and represented in real terms, i.e. adjusted for inflation. Examples of this include the key interest rate and the interbank rate (the rate charged on very short-term loans between banks). If we look at the stock, bond, and real estate markets, however, we see that in these contexts real yields have remained stable over the last few decades, as illustrated for example by the real return on investment. The divergence is due to the risks involved: Investors who are willing to take risks are able to achieve real yields, but risk-averse investors have seen their returns decrease. This has led to a widening gap between between high-risk and risk-averse investment options.

What causes the divergence?

Economist have tried to explain this divergence in a variety of ways. One of the best-known explanations is the one put forth by a team of researchers headed by MIT economist Ricardo Caballero. He has identified several reasons for the observed decline in risk-free real interest rates. One of these factors is a growing global demand for safe assets, i.e. those types of assets that risk-averse investors are interested in. In addition, advances in technology (e.g. automation) have led to a situation where income from work now accounts for a smaller percentage of the overall income generated. These technological changes have also sparked a tendency towards monopolization, allowing monopolies to achieve higher returns. Technological progress is creating barriers to market entry and tendencies favoring economies of scale (for example in the field of social media, where the “winner takes it all” principle reigns supreme).

A normalization of monetary policy

It is highly uncertain when we’ll see a normalization of monetary policy and a return to higher interest rates. For the moment, the trends outlined above show no signs of a reversal. It seems that this period of low interest rates and unusual monetary policies will continue for some time to come.

Maximilian Böck, Institute for macroeconomics