R star?

There’s a couple of very good pieces in the FT (here and here) by Gavyn Davies on fundamental changes to the equilibrium interest rate (R*).  Don’t stop reading now – it’s almost certainly a really important factor for real estate investment decisions and prices.  As Davies states

For decades, no one focused on R* because it was viewed as one of the great constants of the economy. The Fed and everyone else accepted that “normalisation” implied a return to the long run average for real short term rates. That would imply that the Fed funds rate should return to a level of about 4 per cent – 2 per cent real, and 2 per cent for inflation. If that reasoning still applied, it would require an awful lot of monetary tightening from here.

We basically tell our students that the 2% (R*) is the “normal” requirement for loss of liquidity (with inflation and a risk premium added) in a target rate of return estimation. However, there’s now a growing belief that there has been a fundamental shift in the equilibrium interest rate largely due to demographic change.

Although the retirement of the baby boomers may soon start to cause a drop in the US savings ratio, other demographic factors are expected to keep r* abnormally low for a long time to come. The Federal Reserve authors calculate that the current level of the underlying equilibrium real interest rate, based on the state of demography alone, is only 0.5 per cent. This compares with the latest FOMC estimate of 0.9 per cent for r*. That official estimate includes several economic forces other than demography that are also keeping interest rates down, so r* may well be reduced further in coming FOMC meetings.

This seems to imply “abnormally low” bond yields for a long time to come which, in turn, implies, “abnormally low” target rates of return for financial and real estate assets which, in the absence of falls in rental levels, implies “abnormally low” real estate yields for a long time to come.


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