Commentary Type

Are Low Interest Rates Natural or Artificial?


Interest rates in advanced economies are at record-low levels, in some cases even below zero. The prolonged weakness of the recovery from the Great Recession and the sustained undershooting of central bank inflation targets strongly suggest that low interest rates are an equilibrium outcome and not a policy distortion. Several factors are pushing the world toward low interest rates, and those factors may persist for many years.

Central banking has evolved almost beyond recognition of its origins more than 300 years ago. The common element that remains is the determination of the purchasing power of a country's currency—be it in terms of a commodity such as gold, other currencies, or goods and services. Central banks are responsible for that purchasing power, and currently most aim for a low and stable rate of increase in the average price of a broad basket of consumer goods and services. This rate is referred to as the inflation target.

(There is some disagreement as to [a] what rate of inflation should be targeted; [b] how strictly central banks should aim to achieve this target; [c] whether the target should be in levels or growth rates; and [d] whether the target should be cast in terms of prices, wages, nominal GDP, or a dual target that includes growth or employment. Such considerations have little implication for the arguments developed here. The Federal Reserve has a dual target: stable prices [interpreted as low inflation] and maximum employment.)

Central banks achieve their goal by printing money to buy assets. In doing so, they affect the prices of the assets they buy. The traditional asset is a short-term government bond. The price of the bond translates into a rate of interest. Printing more money to buy bonds raises the price of bonds and thus lowers the rate of interest. When inflation is below target, central banks print more money, and the interest rate falls. A lower interest rate stimulates spending, which puts upward pressure on inflation toward its target. Conversely, when inflation is above target, central banks print less money, and the interest rate rises. A higher interest rate restrains spending, which puts downward pressure on inflation.

The central bank's job, in other words, is to print the right amount of money to achieve its target. The interest rate that results is determined in the market. The interest rate that stabilizes inflation at its target is the one that balances desired saving and investment at that constant inflation rate. Quantitative easing and negative interest rates are new terms for recent policy actions, but they are, in fact, natural extensions of traditional monetary policy. Most economists did not think negative interest rates were even possible, given that investors can always hold paper currency in a vault yielding a zero interest rate. However, it appears that holding bonds and other electronic financial instruments is more convenient than storing paper currency, so investors are willing to pay a little bit for the convenience. But there is a limit, perhaps around −1 percent, below which it will not be possible to push rates lower.

When short-term interest rates are at their lower bound of zero percent, or perhaps −1 percent, central banks can ease policy further by buying longer-term assets or even equities. This quantitative easing works by raising asset prices, thus lowering rates of return, just as monetary policy always works.

Market interest rates and measures of expected future interest rates over the next decade or more are at record-low levels. Yet inflation is currently close to its target of 2 percent, and both market-based and survey-based measures of expected future inflation are close to that target. Thus, we seem to be at an equilibrium with a very low rate of interest. The interest rate is also exceptionally low when measured in real terms—that is, the interest rate minus expected inflation over the term of the interest rate.

The Fed's policy statements, with which financial markets broadly agree, point to an increase in short-term interest rates of about 2 percentage points over the next three years. Long-term interest rates also are expected to rise between 1 and 2 percentage points. There is little reason to expect any harmful consequences from a gradual rise in interest rates. Note that real interest rates would still be historically low after those projected increases.

There are at least five reasons for the current low real rates of interest: (a) labor force growth has declined around the world, thereby reducing the need for business and housing investment; (b) a large cohort in many countries is entering the maximum saving years immediately prior to retirement; (c) productivity growth has declined around the world, thus reducing the demand for business investment; (d) regulatory changes have increased the demand for safe assets, including those that are commonly used to quote interest rates; and (e) driven by government policies, developing and emerging-market economies have become net savers instead of net borrowers since 2000. In late 2009, I noted that the decline of real interest rates had been going on for about 30 years, and I pointed to several of those factors. This phenomenon is not limited to the aftermath of the Great Recession.

The slowdown in the growth of the labor force is likely to last a very long time. The retirement bulge, conversely, should eventually reduce the amount of saving at some point and thus become an upward force on interest rates. The other factors are difficult to predict; historically they have tended to be persistent but not permanent. In the United States, the election of Donald Trump may lead to a significantly more expansionary fiscal policy, which would tend to increase interest rates.

On balance, it appears that real interest rates are more likely to rise than fall over the next few years, but they probably will continue to be on the low side of historical experience.

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