Why are interest rates so low? The best answer is that the advanced countries are still in a “managed depression”. This malady is deep. It will not end soon.
One can identify three different respects in which interest rates on “safe” securities in the principal high-income monetary areas (the US, the eurozone, Japan and the UK) are exceptionally low. First, the short-term intervention rates of central banks are 0.5 per cent or lower. Second, yields on conventional long-term government bonds are extremely low: the German 30-year bond yields 0.7 per cent, the Japanese close to 1.5 per cent, the UK 2.4 per cent and the US 2.6 per cent. Finally, long-term real interest rates are minimal: UK index-linked 10-year gilts yield minus 0.7 per cent; US equivalents yield more, but still only plus 0.4 per cent.
If you had told people a decade ago that this would be today’s reality, most would have concluded that you were mad. The only way for you to be right would be if demand, output and inflation were to be deeply depressed — and expected to remain so. Indeed, the fact that vigorous programmes of monetary stimulus have produced such meagre increases in output and inflation indicates just how weak economies now are.
Yet today we hear a different explanation for why interest rates are so low: it is the fault of monetary policy — and especially of quantitative easing, the purchase of long-term assets by central banks. Such “money printing” is deemed especially irresponsible.
As Ben Broadbent, deputy governor of the Bank of England, has argued, this critique makes little sense. If monetary policy had been irresponsibly loose for at least six years — let alone, as some have argued, since the early 2000s — one would surely have seen inflationary overheating, or at least rising inflation expectations. Moreover, central banks cannot set long-term rates wherever they wish. Empirical analysis of the impact of quantitative easing suggests it might have lowered bond yields by as much as a percentage point. But note that yields remained extremely low even well after QE ended, first in the UK and now in the US.
The price level is the economic variable that monetary policy influences most strongly. Central bankers cannot determine the level of real variables — such as output, employment, or even real interest rates (which measure the return on an asset after adjusting for inflation). This is especially true over the long run. Yet the slide in real interest rates is longstanding. As measured by index-linked gilts, they fell from about 4 per cent before 1997, to about 2 per cent between 1999 (after the Asian financial crisis) and 2007, and then towards zero (in the aftermath of the western financial crisis).
There is a more convincing story about why interest rates are so low. It is that the equilibrium real interest rate — crudely, the interest rate at which demand matches potential supply in the economy as a whole — has fallen, and that central bankers have responded by cutting the nominal rates they control. Lawrence Summers, former US Treasury secretary, has labelled the forces “secular stagnation” — by which is meant a tendency towards chronically deficient demand.
The most plausible explanation lies in a glut of savings and a dearth of good investment projects. These were accompanied by a pre-crisis rise in global current account imbalances and a post-crisis overhang of financial stresses and bad debt. The explosions in private credit seen before the crisis were how central banks sustained demand in a demand-deficient world. Without them, we would have seen something similar to today’s malaise sooner.
Since the crisis, central banks have not chosen how to act — their hands have been forced. Events in the eurozone provide a powerful example. In early 2011, the European Central Bank raised its intervention rate from 1 to 1.5 per cent. This was wildly inappropriate, and in the end the ECB had to cut rates again and embark on QE. If central banks are to be a stabilising force, they have to move interest rates in an equilibrating direction — and that direction is not something they can choose.
Rising risk aversion might be another reason why real interest rates on safe securities have fallen. The idea is that the crises increased the appeal of the safest and most liquid assets. This is part of the explanation for ultra-low yields on German Bunds. But it does not seem to be the dominant explanation over the longer run. The gap between the interest rate on treasuries and US corporate bonds has not been consistently wider since the crisis, for example.
We should view central banks not as masters of the world economy, but as apes on a treadmill. They are able to balance demand with potential supply in high-income countries only by adopting ultra-easy policies that have destabilising consequences down the line.
When will we see an enduring rise in real and nominal interest rates? That would require a marked strengthening of investment, a marked fall in savings and a marked decline in risk aversion — all unlikely in the near future. China is slowing, which is likely to depress interest rates further. Many emerging economies are also weakening. The US recovery might not withstand significantly higher rates, particularly given the dollar’s current strength. Debt also remains high in many economies.
Ultra-low interest rates are not a plot by central bankers. They are a consequence of contractionary forces in the world economy. While upward moves in rates seem ultimately inevitable from current levels, it is likely that historically low rates will be with us for quite a while. Those who bet on jumps in inflation and a bond-market rout will continue to be disappointed. The depression has been contained. But it is a depression, all the same.