Historical Yields and Inflation: the Next MPR

The always great FT Alphaville pointed out a recent working paper by the Bank of England that looks at eight centuries of the risk free rate.  (http://www.bankofengland.co.uk/research/Documents/workingpapers/2017/swp686.pdf)  The author builds a data set of the most relevant risk free rate in the world at a particular time, spanning the time period from 1273 to today.  

What does the data show?  Yields generally have ranged between 20% and 1.5% over the period examined.  There have been 9 bull markets in fixed income over that time period lasting anywhere from 10 to 68 years.  The average real yield since 1311 has been 4.78% and has averaged 2.55% over the last 200 years.  Current real rates are ridiculously low.  The author notes that at the end of 2016 the real rate of 0.81% falls short of the 95th percentile thresholds for lowest real rate across the entire data set.  Other fun facts include the absolute bottom in nominal rates occurred in this bull market with US 10 year bonds reaching a low yield of 1.37%.  The last time yields came anywhere close to that was in 1941 when the 10 year touched 1.97%.  As  well, the average length of a bull market on real rates is just short of 26 years.  At 34 years, this current bull market is the second longest.  

There is no doubt, that put into an historical context, nominal and real yields are extremely low.  The fundamentals and more recently the cajoling by central banks to fend off deflation have led to these outlier rates.  

However, what really struck me was the inflation data.  For the last 700 years, inflation has averaged 1.09% and over the last 200 years it has stood at 1.49%, the latter not being far from the current inflation readings in the US and Canada.  I know on their dating profiles our central banks like to take credit for anchoring inflationary expectations but this data would suggest expectations were anchored well before inflation targeting central banks came along. It’s unfortunate for the central banks that inflation may have a “natural” rate well below their 2% target.  You can’t get blood from a stone, so maybe, over the long run, you can’t get sustained inflation to the 2% target level.  No matter how much QE you do.  

As Keynes said, in the long run we are all dead.  So in the meantime we have to deal with central banks that believe they can turn the course of history.  We have to keep playing the game.  

In Canada, we are now “ultra” data dependent (whatever that means, versus being just data dependent).  We just got the inflation reading for September and it appears benign.  The Bank’s favourite measures of core, the three amigos, averaged 1.6%.  This would be .1% above the 200 year average but more significantly still below the Bank’s 2% target.  Although what matters is where the Bank thinks inflation will be in 18 months, the market reads that this will put the Bank on the sidelines on October 25.  Given that the folks on Wellington Avenue are now petrified that some market participants may yell at them again, the odds of the Bank doing nothing are higher than their output gap framework would suggest.