Do long-term interest rates drive GDP and inflation in small open economies? Evidence from Poland by Grzegorz Wesołowski Comments by Dubravko Mihaljek Bank for International Settlements 11th Young Economists’ Seminar Dubrovnik Economic Conference Dubrovnik, 12 June 2016 The views expressed are those of the presenter and not necessarily those of the BIS.

Research questions Does the term premium in the long-term interest rate significantly affect the shock propagation mechanism in the SOE? Does the term premium significantly impact the volatility of output gap and inflation in the SOE? Did changes in investors' sentiment (eg associated with QE) affect GDP and inflation in Poland? What is the estimated impact of long-term interest rates on GDP as compared with the impact of short term interest rates in Poland?

Answers in the paper Does the term premium significantly affect the shock propagation mechanism in SOEs? Seems so, but not clear to me how this works Does the term premium significantly impact the volatility of output gap and inflation in the SOEs? In Poland: yes (output gap), no (inflation). But answers differ for a TP “shock” (no and no)

Answers in the paper (cont) Did changes in investors' sentiment (eg associated with QE) affect GDP and inflation in Poland? No, even though QE lowered long-term IR in Poland What is the estimated impact of long-term interest rates on GDP as compared with the impact of short term interest rates in Poland? 5.1 times bigger effect of short-term IRs

What is this all about? Term premium = Duration risk premium for holding a long-term bond yield: the compensation investors get for locking up their money for long stretches rather than constantly rolling it over Cannot be observed, has to be estimated Some approaches based solely on term structure models using bond yields at a range of maturities, without incorporating macroeconomic variables (eg Adrian et al, 2013) Other approaches based on the joint estimation of macroeconomic and term structure models, which allow the effect of macroeconomic developments to be incorporated (eg Hördahl and Tristani, 2014)

Term premia (cont) Decomposition into term premia and expected interest rates is very tricky and strongly model-dependent (see also FT Alphaville, 4 Sep 2015)

Term premia (cont) Both expected future nominal short-term rates and term premia are currently estimated to be very low. TP estimated at close to zero in the United States, and at –1.5%, in the euro area This means that investors are demanding virtually no compensation for interest rate risk on US government debt … and are willing to pay to take on the risk that long-term interest rates in the euro area will rise

Why is all this important for central banks? Bernanke (Economic Club of NY, 2006): To the extent that the decline in forward rates can be traced to a decline in the term premium, . . . the effect is financially stimulative and argues for greater monetary policy restraint, all else being equal. Specifically, if spending depends on long-term interest rates, special factors that lower the spread between short-term and long-term rates will stimulate aggregate demand. Thus, when the term premium declines, a higher short-term rate is required to obtain the long-term rate and the overall mix of financial conditions consistent with maximum sustainable employment and stable prices. 10

Why is all this important for central banks? But in a simple linearised New Keynesian model, it is the expected path of the short-term RIR that determines the extent of intertemporal substitution and hence current output Long-term interest rates matter only because they embed expectations of future short-term rates This framework does not allow shifts in TP to affect output: the recent decline in TP should be ignored when constructing optimal monetary policy The only important consideration should be the restraining influence of the rising expected rate component 11

Why is all this important for central banks? Given these contradictory practitioner and New Keynesian views about the macroeconomic implications of changes in the term premium, we need to know what economic theory more generally implies about this relationship as well as what the data have to say → Build and examine a structural dynamic stochastic general equilibrium (DSGE) framework that can more completely characterize the relationship between the term premium and the economy 12

Background 13

Background (cont) 14

Background (cont) Historically, nominal GDP growth and 10-year bond yields have lined up reasonably well But recently, bond yields stood a few percentage points below both actual and forecast nominal GDP growth What is going on? Structural factors may have lowered expected interest rates and term premia. Expected interest rates may have fallen due to downgraded expectations of long-term real interest rates (global savings glut, secular stagnation in the core advanced economies)

What is going on? (cont) Structural explanations of the fall in bond yields (cont) Expected future inflation may have shifted downwards as a result of persistent low inflation and structural factors (ageing societies) Term premia may have fallen for the foreseeable future due to financial investors’ structurally higher demand for safe bonds because of favourable regulatory treatment and greater demand for collateral

What is going on? (cont) Alternative view: temporary factors Prolonged low (and even negative) policy rates and forward guidance have pushed down expected future short-term rates Large-scale asset purchases have lowered term premia by absorbing duration risk, inducing portfolio rebalancing and reinforcing policy signals Large foreign official holdings of core bonds have also weighed on term premia Search for yield and safe haven flows have reduced them further post-crisis

Why should all this matter for Poland? The only EU country that didn’t have a recession during the global financial crisis Bond markets tiny compared with major advanced economies GDP and inflation driven by real, not financial sector developments (luckily so for Poland) Monetary policy totally focused on inflation targeting all along, no experiments with unconventional tools And yet the estimated term premium in Poland is lower than in the US – how can one explain this?