Beyond the current fight against inflation: Fiscal policy under low rates

At a time when all the talk is about high interest rates, coming out with a book titled Fiscal Policy under Low Rates seems like bad timing, indeed like a provocation.

The origin of the title is simple. Although I anticipated and discussed in the book the risk of inflation and the need for higher interest rates to get it under control, the book was finished and its title set before the current inflation episode started and while real rates were still extremely low. Had the book come out in print a year earlier, the title would have been seen as totally natural. But current higher rates raise an obvious issue. Is my book in effect a history book, interesting but no longer of direct relevance, or is it still informative for the future?

I want to double down on my pre-COVID pre-inflation answer. I believe that the book is highly relevant for the future. Indeed, and perhaps paradoxically, I see the current episode as strongly supportive of my argument. Even at what is likely to be close to the height of monetary tightening and peak real interest rates, those rates are still extremely low by historical standards, negative in the short run, close to zero in the medium run—and more importantly—lower than the likely growth rates. Once the fight against inflation is won, real interest rates will likely be very low again.

My outlook comes from more than market evidence. It comes from having looked at the historical evidence and the steady decline in real rates over the last 40 years. This decline was not due to specific events, such as the Global Financial Crisis or the initial phase of the COVID crisis. It was due to persistent underlying forces: a combination of high saving, low investment, and a strong demand for safety, leading in combination to low equilibrium real safe rates.

When we emerge from the current fight against inflation, interest rates will again be shaped by these three forces. And, looking forward, I do not see them as sharply turning around. High saving reflects in large part demographics, an increase in life expectancy that will continue to prevail. Given the highly uncertain environment we are likely to be in for some time, the demand for safe assets can be expected to remain strong. The only question concerns investment. If we are to achieve our climate change mitigation goals, we shall need to invest significantly more in green technologies. Higher investment may then lead to higher interest rates. Even under this assumption however, interest rates would likely remain fairly low—lower than growth rates—and the lessons of this book will still apply.

So I am happy with the title and that I chose. I hope it triggers a discussion of macroeconomic policy, looking beyond the current fight against inflation.

Olivier Blanchard, author of Fiscal Policy under Low Rates, is the C. Fred Bergsten Senior Fellow at the Peterson Institute for International Economics (PIIE) and the Robert M. Solow Professor of Economics emeritus at the Massachusetts Institute of Technology (MIT).