Low Real Interest Rates Support Asset Prices, But Risks Rising for Market

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Nassira Abbas is a deputy division chief in the Global Markets Monitoring and Analysis Division of the Monetary and Capital Markets Department at the International Monetary Fund (IMF). Tobias Adrian is the Financial Counsellor and Director of the IMF’s Monetary and Capital Markets Department._____

Supply disruptions coupled with strong demand for goods, rising wages, and higher commodities prices continue to challenge economies worldwide, pushing inflation above central bank targets.

To contain price pressures, many economies have started tightening monetary policy, leading to a sharp increase in nominal interest rates, with long-term bond yields, often an indicator of investor sentiment, recovering to pre-pandemic levels in some regions such as the United States.

Investors often look beyond nominal rates and base their decisions on real rates—that is, inflation-adjusted rates—which help them determine the yield on assets. Low real interest rates induce investors to take more risks.

Despite somewhat tighter monetary conditions and the recent upward move, longer-term real rates remain deeply negative in many regions, supporting elevated prices for riskier assets. Further tightening may still be required to tame inflation, but this puts asset prices at risk. More and more investors could decide to sell risky assets as those would become less attractive.

While shorter-term market rates have climbed since central banks’ hawkish turn in advanced economies and some emerging markets, there is still a sharp difference between policymakers’ expectations of how high their benchmark rates will rise and where investors expect the tightening will end.

This is most obvious in the United States, where Federal Reserve (Fed) officials project