Global Economics Analyst

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1 December, Issue No: / Not So Stagnant Economics Research Since the end of the Global Financial Crisis (GFC), real GDP growth in advanced countries has repeatedly disappointed forecasts despite record-low real policy rates. The secular stagnation hypothesis explains this disconnect with a persistently depressed or even negative real equilibrium policy rate (or r*). But real GDP is a treacherous indicator of cyclical performance in an environment where potential GDP growth is highly uncertain but seems to have slowed much more than generally expected a few years earlier. The labor market is a more robust measure and tells a very different story. The unemployment rate in the G7 has fallen faster in the past five years than over any comparable period since at least the 97s, despite a rebound in working-age labor force participation. In light of these observations, we take another look at estimates of r* in the US, the Euro area, Japan and the UK. We start with a conventional setup and estimate r* with a statistical filter using the performance of real GDP. We then modify the model to measure slack using the unemployment rate. Jan Hatzius () 9-9 jan.hatzius@gs.com Goldman, Sachs & Co. Jari Stehn +()777- jari.stehn@gs.com Goldman Sachs International Karen Reichgott () - karen.reichgott@gs.com Goldman, Sachs & Co. Our estimates confirm that r* has fallen across all four economies since the late 9s, due to both lower trend growth and other headwinds. These headwinds appear mainly secular when we measure activity using the output gap. But the headwinds look more cyclical with a sharper decline after the GFC and more of a rebound since when we measure activity using the labor market. Our analysis points to important differences across countries. The equilibrium rate fell sharply in the US and UK during the GFC but has partially rebounded since then. In the Euro area, however, r* has remained negative, suggesting that the stance of monetary policy is barely expansionary. Japan s r* was depressed during the lost decade of 99-, but has recently started to show signs of normalization. These results are consistent with our forecast that the Fed and the Bank of England will tighten monetary policy soon, and probably by more than discounted in the markets at present. Elsewhere, they suggest that the ECB might still have more work to do than the Bank of Japan, although our estimates in these economies are subject to even greater uncertainty than in the United States. Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to The Goldman Sachs Group, Inc. Global Investment Research

2 December, Not So Stagnant The recovery in real GDP growth after the Global Financial Crisis (GFC) has been disappointing. Year after year, forecasters have revised down their initially optimistic GDP growth projections. This pattern is illustrated in Exhibit, which shows how the consensus GDP forecast for the G7 economies has evolved in the Bloomberg survey of economic forecasters for each year since. Every line ends lower than where it started. Exhibit : GDP Growth Has Disappointed. G7 Consensus Real GDP Growth Forecast :.% :.% Source: Bloomberg. Goldman Sachs Global Investment Research. :.% :.9% :.7% The sluggish growth pace looks especially disappointing in light of persistently negative real short-term interest rates. The secular stagnation hypothesis proposed by Summers () explains this disconnect with a depressed equilibrium policy rate (r*) the real policy rate consistent with price stability and full employment. If the equilibrium rate is depressed, then even a very depressed actual rate might not be all that stimulative. But real GDP can be a treacherous indicator of cyclical performance in an environment where potential GDP growth is highly uncertain but seems to have slowed much more than generally expected a few years earlier. In such a world, a downside surprise in real GDP growth might reflect ) cyclical weakness in aggregate demand relative to a given level of aggregate supply, ) structural weakness in aggregate supply, or perhaps ) an increased statistical understatement of real GDP. Each of these explanations has distinct implications for r*, and only the first is straightforward. In our view, the labor market is a more robust gauge of cyclical performance. The unemployment rate, in particular, directly measures labor demand relative to labor supply. So it is striking that the unemployment rate across the G7 economies has fallen faster over the past five years than in any comparable period since at least the mid-97s (see Exhibit ). Moreover, at least for the G7 as a whole this strong performance is not due to unusual weakness in labor force participation. Exhibit shows that participation for people under years of age has risen in the past five years and is now in the middle of the range seen in the decade prior to the crisis. Weakness in aggregate demand relative to supply for a given level of r implies a lower short-run r*. Weakness in aggregate supply for a given level of r might imply a lower long-run r*, although the strength of the link between long-run growth and long-run r* is uncertain. A greater statistical understatement of real GDP growth has no direct implications for r*. Goldman Sachs Global Investment Research

3 December, Exhibit : Unemployment Has Fallen Sharply G7 Unemployment Rate Source: Goldman Sachs Global Investment Research. Exhibit : Despite Increases in Working-Age Participation 7. G7 Labor Force Participation Rate (- year olds) Source: Goldman Sachs Global Investment Research. 9. Exhibit does not bring to mind the concept of stagnation secular or otherwise. Instead, it shows a labor market that fell into a deep slump in the GFC but has been recovering from that slump in a sharp, V-shaped manner. That recovery is not yet complete, as the unemployment rate remains above the cyclical lows reached in the generally low-inflation post-9s period. But the labor market in the advanced economies has come a long way. Measuring the Equilibrium Rate The reasoning so far is admittedly rather loose and subject to several challenges. First, r* is technically not defined as the rate consistent with a particular pace of labor market improvement but as the rate consistent with full employment. Second, it is in principle possible to reconcile even a strong labor market with a depressed equilibrium rate when that improvement occurs with a very depressed actual real rate. Third, the unemployment rate is not a perfect measure of slack because of potential changes in the structural rate. Fourth, Exhibit hides a lot of variation across the major economies. Goldman Sachs Global Investment Research

4 December, If we really want to investigate the secular stagnation hypothesis, we need to be more explicit and precise. We therefore construct simple models of r* in the United States, the Euro area, Japan and the UK. In general, we follow the Laubach-Williams approach and use statistical techniques to back out the evolution of r* from the behavior of economic activity and the actual real interest rate. As in Laubach-Williams, we model r* as the sum of potential growth and other "headwinds" that are assumed to be persistent (follow a random walk ). We simplify the Laubach-Williams approach, however, by taking estimates of the output gap and potential growth estimates from the CBO for the US and the OECD for other countries. The box on page explains our methodology in more detail. We then modify the model to measure economic performance using an unemployment gap instead of the output gap. We again use CBO estimates for the structural unemployment rate for the US and OECD data for the other countries. Also, we adjust the US unemployment series to take into account broader U slack. Exhibit : A Rebound in Equilibrium Rates United States Euro Area Actual r r* with GDP r* with U-rate Actual r r* with GDP r* with U-rate Japan United Kingdom Actual r Actual r r* with GDP r* with GDP r* with U-rate r* with U-rate Source: Goldman Sachs Global Investment Research. See Thomas Laubach and John Williams (). "Measuring the Natural Rate of Interest," Review of Economics and Statistics, vol., pp. -7. The assumption of a random walk for the headwinds is in line with LW s preferred specification but differs from our previous analysis for the United States, where we allowed the headwinds to follow an AR() process. See The Rebound in the Equilibrium Funds Rate, US Economics Analyst, May 9,. Using an AR() process in the present analysis would translate into even more cyclical patterns for r* than in our baseline results. Goldman Sachs Global Investment Research

5 December, Exhibit shows r* estimates for each of our four economies, and Exhibit breaks down r* into the contribution from potential growth and the contribution from other headwinds. Exhibit : Due to Receding Headwinds United States Euro Area Potential growth - Headwinds with GDP Headwinds with U-rate Japan Potential growth Headwinds with GDP Headwinds with U-rate United Kingdom Potential growth - Headwinds with GDP Headwinds with U-rate Potential growth Headwinds with GDP Headwinds with U-rate Source: Goldman Sachs Global Investment Research. We reach three main conclusions. First, our estimate of r* has fallen across all four economies since the late 9s in both versions of the model (Exhibit ). This decline is due to both lower trend growth and other headwinds (Exhibit ). These might include temporary post-crisis headwinds such as tight mortgage lending standards but also other and potentially more permanent factors such as the global savings glut, rising inequality, financial regulation and technological changes. Second, the r* estimates look much more secularly depressed when we measure economic performance using the output gap (grey line) than the unemployment gap (light blue line). Using the latter which we think is a better measure of cyclical performance the r* estimates look more cyclical with a sharper decline after the GFC and more of a rebound since then. Exhibit shows that the labor-market based model estimates that the headwinds have been more cyclical. Third, we find important differences across countries. In the US and UK r* fell sharply during the GFC but has rebounded since then. In both cases policy has been expansionary for a few years now. In the Euro area r* fell sharply with the GFC but then remained deeply Goldman Sachs Global Investment Research

6 December, negative as the Euro area crisis unfolded. Only recently has r* started to rebound as the ECB turned to more aggressive stimulus but policy is still tight. Japan looks quite different. Policy was tight during the lost decade of 99-. But even in Japan r* has recently started to rebound as the unemployment rate has dropped. How Certain Can We Be? It is important to stress that these estimates like those of other studies, including Laubach-Williams are based on strong assumptions and are subject to very large errors. For example, Exhibit shows that the standard error around our r* estimate for the US is about basis points (bp). That is, the 9% confidence band for our estimate of the latest r* in the US stretches from -.% to +.%. These errors are similar to those in the original Laubach-Williams model. The corresponding error band is even wider for the Euro area, which has standard error of about bp, as it is even harder to identify a relationship between real interest rates and economic activity. Exhibit : r* Estimates are Very Uncertain United States r* Euro Area r* r* + SD r* - SD r* + SD r* - SD Source: Goldman Sachs Global Investment Research. That said, our main finding that advanced economies have not entered an era of secular stagnation is consistent with other recent evidence. First, a number of other studies have concluded that r* is expected to rebound from current levels in the United States. For example, recent estimates including work by the IMF, Fed staff, the US Monetary Policy Forum, and our earlier study on r* in the US suggest that r* is currently close to zero in the United States but the median of these estimates points to a rebound to around ¼% in coming years (Exhibit 7). All of these studies, however, point to very large uncertainty around this central case. The number of post-crisis estimates for the other economies appears limited. Our European team recently estimated that r* remains negative (between around -% and -.% depending on the specification) but is expected to rise going forward. A recent Bank This finding is consistent with our European team s previous estimates; see Dirk Schumacher, The fall and (likely) rise of the Euro area neutral real rate, European Economics Analyst, April,. See Dirk Schumacher, The fall and (likely) rise of the Euro area neutral real rate, European Economics Analyst, April,. Goldman Sachs Global Investment Research

7 December, of England staff note concluded that r* is assumed to recover from zero at present to a little under.% over time. Exhibit 7: Recent r* Estimates Point to a Rebound in the US Study r* Estimates (%) Current Projection Laubach and Williams () -. -.* Hatzius and Stehn ()..7 IMF ().**. to. Hamilton et al () - to Kiley ()** -. Curdia () -..9 Laubach and Williams () -.. Yellen () close to - Median.. * Implied by structure of the model, as r* is a random walk. ** Approximate, inferred from charts in the paper. Source: Compiled by Goldman Sachs Global Investment Research. Second, the long-run historical perspective suggests that current real rates remain unusually low. We constructed a database of short-term interest rates in a sample of 9 advanced countries stretching back mostly to the s. 7 Although the volatility is enormous, we find that short-term rates have fluctuated around % in real terms (Exhibit ). So the average US real rate of the postwar period looks reasonably representative of the longer-term historical record. The long-term historical evidence also shows only a weak relationship between real rates and real GDP growth, so we would only adjust this % estimate moderately for the slower pace of potential GDP growth. Exhibit : The Historical Distribution of Real Policy Rates Relative frequencies (%) Relative frequencies (%) Global US Real rate (%) Source: Global Financial Data. Haver Analytics. Goldman Sachs Global Investment Research. See Goldby, Laureys and Reinold (), An estimate of the UK s natural rate of interest, Bank Underground blog, Bank of England. 7 See Jan Hatzius, Sven Jari Stehn and Jose Ursua, Some Long-Term Evidence on Short-Term Rates, US Economics Analyst, June,. Goldman Sachs Global Investment Research 7

8 December, All told, we think the evidence both our own and that provided by other economists points to three conclusions. First, r* was likely well below zero in the immediate aftermath of the GFC. In other words, it took deeply negative real rates or their equivalent to put the global economy on course for recovery. This was a strong justification for unconventional monetary easing as well as aggressive fiscal stimulus in the early part of the recovery. Second, there are strong signs that r* has risen, at least in those parts of the global economy where the crisis has faded into the background. The current level is hard to pin down, but our best judgment is that it is still negative in the Euro area but slightly positive in the US, the UK and perhaps also Japan. Third, we expect r* ultimately to move back into the %-% range, only moderately below the historical norm, although economies such as Japan and the Euro area, with particularly adverse demographics and therefore particularly depressed potential growth, may find themselves at the bottom end of that range. Policy Implications A number of important policy implications emerge from these conclusions. First, our estimates are consistent with our forecast that the Fed and the BoE can start normalizing monetary policy soon, on December in the case of the Fed and in Q in the case of the BoE. At this point, with r* still relatively close to and core inflation still well below target, these central banks certainly do not appear to be behind the curve to any significant extent. But should the speed of the recent rebound of r* continue, they might well have to normalize policy more sharply ahead of the exceptionally slow pace now priced by the bond market. Second, our analysis supports this week s adoption of additional easing by the ECB, as the actual real policy rate still exceeds r* even when activity is measured on the basis of labor market indicators. In fact, our results suggest that the ECB might still have to do more than the relatively underwhelming step taken on Thursday. Third, our estimates suggest that the BoJ might not have too much additional work to do. With actual real rates now below r* and QQE still rapid, monetary policy now looks clearly expansionary for the first time in at least two decades. However, core inflation measured in the Western way, i.e., excluding not just food but also energy is still well below the % target, which is one key reason why our Japan economists still expect another easing step next year. Finally, central banks need to take into account the very large uncertainty around estimates of r*. This uncertainty is another reason for continued accommodative monetary policy in the Euro area, given the asymmetry of risks at the zero bound. But it is also an argument to proceed cautiously with the normalization process in the US and UK. In light of this uncertainty, the estimated gap between the actual and equilibrium interest rate should only be used as one indicator of the stance of monetary policy, in addition to other measures including summary indicators of overall financial conditions. Jan Hatzius Sven Jari Stehn Goldman Sachs Global Investment Research

9 December, Box: A Simple Model of the Equilibrium Rate We estimate a simplified version of the Laubach-Williams model for the US, Euro area, Japan and UK. The model consists of three equations. First, the behaviour of economic activity ( ) depends on a lag and the lagged gap between the actual real interest rate (r) and the estimated equilibrium real interest rate (r*). where economic activity (x) is measured either with an output gap (actual less potential real GDP) or an unemployment gap (actual less structural unemployment) and denotes an error. The second equation describes r* as the sum of potential growth (g*) and other headwinds (z): The third equation describes the evolution of the headwinds as a random walk (where denotes an error): Our sample is quarterly and extends back to 9 for the US and 97 for the Euro area, Japan and UK. We take the output gap, potential growth and the structural unemployment rate from the Congressional Budget Office for the US and from the OECD for the other economies. We extrapolate the OECD estimates backwards to 97 using an HP filter. We amend the US unemployment rate with the difference between the official rate and the U rate to measure broader labor market slack. The actual real interest rate is calculated as the nominal policy rate minus year-over-year core inflation. We use Euro area wide data from the 99s and German data beforehand. We estimate r* using the Kalman filter. Following Laubach and Williams, we pin down the variance of the error in the headwinds equation ( ) as a function of the variance of the error in the activity equation ( ) and the interest-rate sensitivity ( ). Our model struggled to identify the interest-rate elasticity for the Euro area and Japan in the version that uses the unemployment gap to measure economic activity. We therefore imposed the interest elasticity obtained from the output gap version (scaled by an Okun s law relationship). Goldman Sachs Global Investment Research 9

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