The economic landscape: structural change, global R * and the missing-investment puzzle − speech by Andrew Bailey

Speech

Introduction

Thank you. It is a pleasure to speak at this event hosted by the OMFIF. In challenging times like those we are currently facing, the independent platform you provide – which brings the public and private sector together to discuss issues relating to central banking, economic policy and public investment – is more important than ever.

The dominant theme for central banks around the world currently is the very elevated level of inflation. The Bank of England is certainly no exception, with UK CPI inflation reaching 9.1% in May, and projected to increase further to slightly above 11% by October.

In view of continuing signs of robust cost and price pressures, including the current tightness of the labour market, and the risk that those pressures become more persistent, the Bank’s Monetary Policy Committee voted to increase Bank Rate by a further 0.25 percentage points at its latest meeting in June. This was the fifth increase in rates since December, taking Bank Rate to 1.25%.

In the Minutes of that meeting, the MPC emphasised that it will take the actions necessary to return inflation to the 2% target sustainably in the medium term, in line with its remit. The scale, pace and timing of any further increases in Bank Rate will reflect the Committee’s assessment of the economic outlook and inflationary pressures. The Committee will be particularly alert to indications of more persistent inflationary pressures, and will if necessary act forcefully in response. Bringing inflation back down to the 2% target sustainably is our job, no ifs or buts.

Tonight I will step back from the current situation and consider some of the longer-term forces affecting our economy, and shaping the economic landscape in which monetary policy is conducted.

Assessing the policy landscape

Monetary policymakers are typically focused on cyclical movements in the economy, since monetary policy is often thought to have its most powerful effect on inflation 18-24 months ahead. As cyclical shocks hit the economy, monetary policymakers must analyse incoming data to identify the underlying causes and form a view on their implications for the outlook for GDP and inflation. Adjusting policy in response to the cyclical shocks in the foreground of the macroeconomic picture is therefore a core part of our role.

In the background of this picture, however, are some slow-moving but important structural changes, such as trends in population and demographics, technological changes (like increased automation and the rise of intangible capital), and environmental factors (like climate change and the transition to net zero). These slow-moving forces may not influence the setting of monetary policy meeting by meeting. But understanding the broader policy landscape is important, because it provides insights into the economic trends that will shape policy decisions in the longer term.

Economists have developed a number of so-called ‘equilibrium’ concepts that help to summarise key parts of the policy landscape. Of particular relevance for my speech today is the ‘equilibrium real interest rate’, which is the hypothetical real interest rate that would sustain output at potential and inflation at target.^{footnote [1]}

Because the equilibrium real interest rate is a theoretical variable, rather than one we can directly observe, it must be estimated and several approaches have been developed to do so.^{footnote [2]} All of these estimates are, however, associated with a high degree of uncertainty. As a result, the equilibrium real interest rate is typically used to look back on past policy and its stance, or to provide an indication of the general outlook for interest rates over the coming years, rather than as a direct guide to policy.

In the August 2018 Inflation Report, the MPC set out its framework for thinking about the equilibrium interest rate, which is also described in further detail in a background paper co-authored with Bank staff that will be published alongside this speech.^{footnote [3]} That framework decomposes the equilibrium real interest rate, sometimes called r*, into the sum of two components. The first component, called the ‘trend real rate’ or upper-case R* for short, is driven by long-term structural factors. The second component of (lower-case) r* reflects the effects of cyclical shocks to both aggregate demand and supply and so can vary substantially over the short to medium term.^{footnote [4]}

My focus today is on the structural narrative that shapes the policy landscape in the long run. Accordingly, I will look at the trend real rate (upper-case R*) and in particular at its determinants at the global level over the past sixty years or so. For an open economy like the United Kingdom, the trend real rate is pinned down by global forces; as capital is free to move around the world, interest rates would depend on the balance of savings and investment in other countries as well as the United Kingdom. Global R* thus acts as a long-term anchor for the UK’s domestic equilibrium real interest rate. Understanding the relative importance of the different secular factors that drive Global R*, therefore, sheds light on the forces that may ultimately shape the evolution of domestic real interest rates.

While Global R* affects the level around which equilibrium real interest rates fluctuate over the longer term, it abstracts from the shorter-term cyclical forces at play. So let me be very clear that nothing I say today is intended to be a signal about the near term path of the equilibrium real interest rate in the United Kingdom or indeed Bank Rate over the MPC’s policy horizon. Even if the trend global real rate remains low, we may still see a rise in nominal policy rates and equilibrium real interest rates in the short to medium term. In other words, Global R* is an important underpinning, but it is not a useful guide to real-time policymaking.

Since real interest rates are an important determinant of investment, in today’s speech I will also consider the extent to which investment has responded to movements in the trend real rate. As I will discuss in more detail later, the determinants of, and prospects for, investment have important implications for another equilibrium concept that helps us to understand the policy landscape: potential output, which is the hypothetical level of output that could be produced if all resources were fully employed.

Global R*

To illustrate the context, Chart 1 shows the UK ten-year real interest rate, measured directly from index-linked bond prices, plotted to the end of June of this year. Two things stand out immediately. The first is that the real interest rate can be quite responsive to cyclical shocks, sometimes moving by a percentage point or more in a matter of months. Indeed, in the past few months we have seen a relatively sharp and sizable increase. Whether such movements persist depends on the underlying shocks driving real interest rates. For example, we saw a similar rise in the ten-year real interest rate after the global financial crisis and that did not persist when inflation returned to target.

The second observation is that, beneath the month-to-month volatility, there appears to have been a fairly steady downward trend since the mid-1980s. As shown in Chart 2 other economies have experienced a similar trend in real interest rates.^{footnote [5]}

This pattern is suggestive of a structural trend in the underlying global trend real interest rate, in other words Global R*. This concept can be estimated, using a variety of statistical methods, all of which extract an underlying slow-moving trend from the more volatile data.

Some of these estimates, from a range of different academic papers, are shown in Chart 3. The teal line shows a new estimate by Bank staff, based on data for 31 high-income countries. Though there are relatively wide error bands around this central estimate, and alternative estimates from the literature exhibit different patterns, the direction of travel has been clear. In other words, a decline in Global R* over recent decades is common across estimates.

While these statistical estimates help us to understand the dynamics of the trend real rate, they do not tell us why it has been falling. The dynamics of the trend real rate are determined by slow-moving structural factors that affect the balance between the demand for capital for production and the stock of wealth available to finance it.^{footnote [6]} Understanding the underlying structural trends that drive this balance requires a structural model.

Recent research by staff at the Bank has developed a model of the world economy that brings together several key structural factors that could account for the decline in Global R*.^{footnote [7]} These are productivity growth, population growth, longevity, the relative price of capital, and government debt. The structural model generates a path for Global R*, as well as a decomposition of the contribution of each of these factors.

Some key results of this exercise are laid out in Table 1. This includes both the baseline model simulation, and a range of alternatives that vary some key underlying parameters and assumptions. It focuses on the period since 1985, given the attention it has received in much of the existing literature. The sample ends in 2015 due to the process used to extract the underlying trends in the structural factors and the timeliness of some of the data required for the simulation.^{footnote [8]} Given the focus on slow-moving structural drivers, omission of the most recent data is unlikely to have a material effect on the estimate of the trend real rate. And I will come on to consider the more recent period and the potential impact of the Covid pandemic later in the speech.

Table 1 shows that, in the structural model, Global R* falls markedly between 1985 and 2015. The total decline of 1.9 percentage points is driven by the response to the five global trends mentioned earlier.^{footnote [9]} The baseline structural model simulation matches the median change over the same period from the statistical model in the earlier chart (reported in the last row of the table), though both are subject to a wide range of uncertainty.^{footnote [10]}

With respect to the main drivers of this decline, two factors – population ageing and a slowdown in productivity growth – play the largest roles in explaining the dynamics of Global R*.

The productivity growth slowdown across advanced economies has been discussed extensively in existing work.^{footnote [11]} Productivity growth impacts R* through firms’ optimal level of capital for production, in other words the demand for capital from firms. Lower productivity reduces the potential returns on new investment (the marginal product of capital) and this reduces firms’ demand for capital at a given interest rate. In equilibrium this reduction in demand lowers R*. The model simulations suggest that this effect accounts for almost half of the decline in Global R* over this period.

Population ageing has been driven by a decline in population growth rates relative to the high levels seen following the Second World War and a marked increase in life expectancy. Importantly, however, in the model the impact of ageing comes almost entirely from the rise in longevity, rather than the decline in population growth rates.

What this means is that the effect of population ageing on the trend real rate is not a consequence of the so-called ‘baby boom’. Instead, it reflects the fact that the oldest generations in the population – including older retirees – also tend to be those who have accumulated the most wealth. This naturally occurs as households accumulate wealth over their working life, in order to fund their retirement. This means that a shift in the age distribution towards these cohorts, in other words population ageing, will increase total wealth in the economy.^{footnote [12]} The equilibrium real interest rate falls to incentivise firms to invest this additional wealth into productive capital.

It is important to note that the mechanism is driven by the relative wealth levels of different cohorts within the population. It is true that, on average, retirees have low savings rates, as they run down their wealth to finance their retirement. However, the data show that in practice this effect is typically not very strong, so that the average household appears to broadly maintain their wealth during retirement. This tempers the extent to which the retirement of the baby-boom generation reverses the impact of ageing on the real interest rate.^{footnote [13]}

These results imply that the effect of population ageing on Global R* has been large, and is expected to persist. While the paths of the underlying drivers are estimated only until 2015, the model-based simulation implies that the equilibrium real interest rate will continue to adjust until the population structure and stock of global capital reach an eventual ‘steady state’. Indeed, the simulation implies that the effects of past structural trends would continue to reduce Global R*, perhaps by another 1 percentage point, over the very long run.^{footnote [14]}

So, importantly, what this model, and the data behind it, are telling us is that we should not expect that ageing, and the retirement of baby boomers, will lead to significant upward pressure on Global R* over coming years or decades. The substantial contribution of population ageing to the decline in Global R* in the past stems from the steady increase in longevity, and this mechanism leads to permanently lower Global R*.

But, of course, this is not a precise forecast of the level of Global R*. Among the risks to this assessment are the other potential drivers that have not been considered in this model. For example, one potentially important driver, which is absent from the structural model simulation, is the rise in inequality. Existing results tend to suggest that the rise in inequality, as seen in recent decades, puts downward pressure on Global R*.^{footnote [15]} Another widespread trend that could push in the opposite direction is the growth in the provision of publicly-financed social security and healthcare. Rachel and Summers (2019) argue that that this trend would both reduce the incentives for households to accumulate wealth and crowd out private capital, resulting in upward pressure on Global R*.

Of course, both inequality and social security provision are themselves endogenous to other underlying structural forces, including the demographic trends that I have already talked about. So incorporating these into our narrative requires a fuller consideration of these interactions.

The Missing-Investment Puzzle

I will now consider one of the potential implications of the past decline in Global R*, focusing on investment.

Standard neoclassical theory, such as that underlying the structural model considered earlier, implies a strong co-movement between the safe real rate and rate of return on capital. This suggests that we would expect a fall in Global R* to be associated with a fall in the return on capital. But while risk-free rates have been falling globally in recent decades, measures of the rate of return on productive capital across high-income economies have not.^{footnote [16]} As the return on capital has remained stable, as shown in Chart 4, while the safe rate and cost of funding has declined, a wedge has opened up between the return on firms’ investment and the cost of financing it.^{footnote [17]}

Chart 5 plots the wedge between the return on capital and risk-free rates for a broad group of high-income economies since 1990.^{footnote [18]} If the return on capital had comoved with the risk-free rate, the wedge would have been stable over time. However, the wedge has increased in most countries, as shown by the blue swathe. The median increase of around 5 percentage points is broadly similar to the rise in the wedge in the United Kingdom (shown in orange).

In standard economic theory, this wedge, between the return on firms’ investment and the cost of financing it, is a measure of firm profitability. As such, it is a key determinant of investment. Accordingly, we might expect to have seen an increase in investment activity alongside the recent increases in the wedge. But, while the wedge has increased, across the same group of countries, as shown in Chart 6, investment has steadily declined, or, at best, remained stable. In the United Kingdom, shown in the orange line, this decline has been particularly stark since the late 1990s. So, across high-income countries, investment has been low in spite of a rising wedge between the realised return on capital and funding costs: this is what I will refer to as the ‘missing-investment puzzle’.

Chart 6: Nominal investment-to-GDP ratio has declined

Footnotes

• Note: High-income countries include Finland, Italy, Netherlands, Spain and the United Kingdom. Figure A.3 in Appendix to Bailey et al. (2022) shows that this result is true for a larger sample of countries from 1987. See Appendix A.2 to Bailey et al. (2022) for data definitions. Source: Authors' calculations using EU KLEMS, the Penn World Table 10.0 and the Jordà et al. (2017) Macrohistory Database. See Appendix A.1 to Bailey et al. (2022) for more details.

To better understand this missing-investment puzzle we conduct a regression analysis, using historical national accounts data to study the relationship between investment and the wedge since 1970. Chart 7 shows the observed investment rate (orange line) and its estimated value from its historical relationship with the wedge (blue dashed line). The increasing unexplained gap between the two lines illustrates and quantifies the extent of the puzzle. It shows that UK investment has remained persistently below the levels that would have been predicted from the observed changes in the wedge since the early 2000s.

Chart 7: The missing-investment puzzle in the United Kingdom

Footnotes

• Note: The chart shows the observed investment rate (net investment to lagged capital stock, in orange), and its value predicted from its estimated historical relationship with the wedge (in blue), both in percentage points. See Appendix B to Bailey et al. (2022) for full details. Source: ONS, Jordà et al. (2017) Macrohistory Database and authors' calculations.

The key question, then, is what structural factors can account for this puzzle? To explore this I will draw on new analysis in the accompanying paper, using industry-level data for the United Kingdom.^{footnote [19]} That analysis considers the role of mismeasurement of capital, as well as the role of competition, financial frictions and corporate governance.

In contrast with the existing literature studying the United States, the results find little role for changes in competition.^{footnote [20]} For the United Kingdom, intangible investment plays the most important role.

Indeed, there has been a strong trend in the composition of investment by firms, moving away from physical capital, such as buildings and machinery, towards what is called intangible capital, such as research and development, software, databases and branding. Measuring investment in intangible assets is challenging. So, although national accounts methodologies are continually improving, existing approaches might be missing part of firms’ investment. That would result in an over-estimation of the observed return on capital and, in turn, the wedge.^{footnote [21]}

This issue can be partly addressed using newly-available data covering a broader range of intangible assets that are currently not included in the national accounts. These data can be used to construct more comprehensive measures of net investment rates and the wedge between the return on capital and risk-free rates.

Adjusting for intangibles, by re-running the regressions on a measure of the wedge constructed using the new data, reduces the size of the missing-investment puzzle as shown in Chart 8. It shows the deviation of the observed investment rate from the rate predicted by its estimated historical relationship with the wedge: what I have identified as the puzzle. The chart compares this deviation when the historical relationship is estimated using two alternative data sources. The orange line shows the case when unadjusted data are used and the blue line shows the case when the relationship is estimated using data adjusted for intangibles. When the adjusted data are used, the gap is smaller throughout the period and almost disappears in recent years.

The remaining puzzle is mostly concentrated immediately after the global financial crisis, and so it is possible this is not driven by structural factors, but rather the lingering impact of the global financial crisis, for example related to the sluggish demand recovery or financial frictions.^{footnote [22]}

While the results suggest an important role for intangibles in explaining the missing-investment puzzle, a few notes of caution are in order. It could be that certain drivers of investment, such as financial frictions, are captured more accurately only at more granular level, such as in firm-level data. Moreover, there could be large non-linearities related to the nature of the global financial crisis that cannot be captured by the simple regression framework used above. So there is clearly still lots of work to do, and I hope to see more research dedicated to this subject in the future.

Intangibles and Productivity

I can now come full circle and consider the implications of the findings so far for another important equilibrium concept: potential output. As intangibles seem to be important for the puzzling weakness of investment, can they also help us rationalise recent developments in productivity and hence the implications for potential output?

Since the global financial crisis we have observed a substantial productivity puzzle. Average labour productivity growth in the United Kingdom has been around 1.3 percentage points lower since the crisis. While intangibles help to explain the missing investment puzzle, their effect on productivity is mixed as, if anything, there is evidence that they might be driving this productivity slowdown. Chart 9 shows that intangible-intensive industries have experienced the strongest slowdowns in labour productivity growth since the global financial crisis, consistent with a recent study by my colleague Jonathan Haskel.^{footnote [23]}

Unfortunately, there does not seem to be a consensus yet on what exactly lies behind this observed relationship. A growing literature shows that there are barriers to intangible investment, for example because intangible assets cannot be easily used as collateral.^{footnote [24]} Thus, the tightening of financial conditions following the global financial crisis could have disproportionally hindered the development of intangible-intensive industries, with potentially long-term consequences for productivity growth.^{footnote [25]} However, intangible investment has recovered in recent years, while productivity growth has remained weak. Could it be, perhaps, that the barriers to intangible investment benefit investment by low-productivity firms? Or are other factors at play?

Other recent studies have highlighted the impact of the intangible economy on competition. Intangible technologies tend to require large upfront investments, what economists call fixed costs. This may give firms with high-intangible adoption a competitive advantage and make it difficult for new innovative firms to enter the market. In that case, entrenched incumbent firms may have fewer incentives to innovate, potentially slowing innovation adoption in the long run.^{footnote [26]}

However, the UK data do not seem to provide strong evidence in favour of this second mechanism, compared with research studying the United States. While the US literature reports a decline in business dynamism and an increase in market power alongside the rise of intangibles, business dynamism seems to have been less affected in the United Kingdom. For example, firms’ entry and exit rates have been stable in the United Kingdom since the early 2000s, in contrast to the declining rates observed in the United States.^{footnote [27]}

Taking stock and looking ahead

My remarks today have purposefully abstracted from short-run influences on the macroeconomy in order to focus on the longer-term structural trends that have driven the secular decline in Global R* and the puzzling weakness of investment in the United Kingdom and other advanced economies. Why do these secular developments matter for central banks?

The level of the trend real rate has important implications for the conduct of both monetary and financial policies. In a low interest rate environment, other things equal, monetary policy may find itself more often constrained by the effective lower bound on nominal interest rates (Bernanke et al., 2019). But prolonged periods of low interest rates may also pose financial stability risks via greater risk taking (Cunliffe, 2019).

Understanding the trends in investment is also key given the importance of investment in driving long-run growth and productivity. In turn, productivity growth is an important determinant of potential output. Estimates of potential output are used to assess the size of the output gap, or level of spare capacity, which influences the degree of inflationary pressure in the economy. Such estimates can therefore have an important influence on the judgements that inform monetary policy decisions.

The analysis I have discussed so far has looked at a number of secular trends over the past few decades. In the current uncertain environment, it is a challenging time to make predictions about the future. Nonetheless, to conclude let me say a few words on what these results might imply for the policy landscape going forward.

As I discussed earlier, the new analysis presented in this speech suggests that the effects of the key drivers of Global R*, particularly increasing longevity, are expected to persist. Absent a significant reversal in the key trends that have driven down Global R*, we may expect it to remain low. So it is not unreasonable to expect that Global R*, the long-run anchor for UK equilibrium interest rates, will remain low. Therefore, cyclical adjustments in short-term nominal interest rates – like those we are currently witnessing in the United Kingdom and abroad – will for the foreseeable future continue to be played out against the backdrop of low global equilibrium real interest rates.

While we have considered several important drivers of Global R* in the past, other factors may come into play over time. You may wonder, for example, whether the pandemic could have impacted some of the key drivers of Global R*, such as productivity growth.

The simple answer, of course, is that we do not yet know. It is too soon to tell what the long-run impact of the pandemic will be for the economy. These impacts are also difficult to disentangle from the effects of the change in trading arrangements between the United Kingdom and the European Union that may already be weighing on productivity (Bank of England, 2021).

However, it is worth bearing in mind that, while the pandemic was a large and unprecedented economic shock, with profound changes to labour markets and the way we work, it is possible that its long-run effects on productivity will be small. For example, the latest ONS estimates of UK labour productivity appear to be in line with pre-pandemic trends. This headline figure, of course, masks several factors at play. There are compositional effects, which appear to have raised productivity measures during the pandemic, because the worst-hit sectors were also the ones with lowest labour productivity. There were also unprecedented challenges to measuring productivity, including the measurement of hours worked during lockdowns. Overall, the long-run impact of the pandemic on trend productivity growth, and hence trend R*, is highly uncertain, though plausibly small.

Perhaps a more salient emerging risk for Global R* is the impact of climate change and the transition to net zero. Neither the size nor direction of this effect are clear. For instance, increased investment by firms looking to adopt the latest green technologies could raise equilibrium interest rates, at least during the transition. On the other hand, Global R* could be pushed down due to higher volatility and uncertainty, including uncertainty about the transition path towards carbon neutrality. This could lead to higher risk premia and structurally higher levels of precautionary saving by households. Understanding and monitoring these channels is an important task for central banks going forward. This is why assessing climate change is not a dilettante matter for central banks.

With regard to the increasing importance of intangible capital, the new results I reported earlier have shown that this has important implications, not only for how we measure capital, but also for the prospects for potential output and productivity.

The inclusion of intangibles would lead to an upward revision to the level of GDP (this happened in 2010 with the inclusion of R&D). The impact on GDP growth going forwards is more ambiguous, and would vary by time period – it will depend on the relative growth of intangible investment.

Changing the measurement of intangibles would in principle affect both the measurement of output and potential output. So, it is not the case that the output gap, and hence the stance of monetary policy, would differ. Similarly, what matters for the trend real rate, R*, is how intangibles affect productivity growth in the long run, which is less about data revisions and more about the long-run impact of intangibles.

We have just scratched the surface though: indeed, the findings of our recent research have left us with as many new questions as answers. Are there more factors, beyond intangibles, responsible for the puzzlingly low level of investment? Why was productivity in intangible-intensive industries hit the most by the global financial crisis? And how do these trends differ in the United Kingdom relative to its international counterparts?

Further work to answer these questions will have important implications for the long-term policy landscape. There’s an old dictum, sometimes attributed to Dwight Eisenhower, that “what is important is seldom urgent and what is urgent is seldom important”. Whatever its providence, there are certainly exceptions to this rule. The recent sequence of extremely large shocks to the global economy and the implications for inflation and activity clearly qualify as both urgent and important. They are the dominant theme for monetary policy deliberations around the world, as I said at the start of this speech. While not urgent, in the sense of shaping the near-term course of monetary policy, understanding the structural trends I have discussed today is no less important. Indeed their effects may be felt for decades to come.

Thank you.

I would like to thank Ambrogio Cesa-Bianchi, Saba Farooq, Marco Garofalo, Richard Harrison, Karen Jude, Nick McLaren, Sophie Piton, Rana Sajedi and Alison Schomberg for their assistance in preparing these remarks. I am also grateful to Saleem Bahaj, Stuart Berry, Alan Castle, Maren Froemel, Andy Haldane, Jonathan Haskel, Sara Holttinen, Peter Goodridge, Clare Macallan, Catherine L. Mann, Josh Martin, Marko Melolinna, Huw Pill, Lukasz Rachel, Michael Saunders, Martin Seneca, Fergal Shortall, Sophie Stone, James Talbot, Silvana Tenreyro and Gavin Wallis for insightful comments and discussions.

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