Torrens feels like he is in some topsy turvy Alice in Wonderland world. It has been a year since he last wrote. And, to be frank, Torrens reckons that maybe he went down a hole and came back in the past. Twelve months ago, the global recovery that was meant to start in 2010, was faltering in much the same way as it is today.
Indeed, this situation has lasted not just one or two years, but much longer. For the last 5 years or so, central bankers in many countries have kept interest rates at close to zero (pretty much as low as they can go) and employed other tools in an effort to provide the support that the global economy needs.
This got Torrens wondering about life at the zero lower bound – how did we get here and what is different about the world when interest rates are at the zero lower bound?
So why are interest rates at the zero lower bound? Short term interest rates reflect a combination of two elements – the expected rate of inflation and a real return. The real return is just the inflation adjusted rate of interest — the monetary interest rate minus inflation. The inflation rate is largely determined by central bank policy (and for now, let’s just assume that central banks are able to keep inflation on target at 2 percent per year). That leaves the real return as the main explanation behind the currently low level of interest rates. The real rate of interest reflects the ability and willingness of firms to invest today’s savings and transform them into future production and the willingness of households to save in the first place. Right now, if you live in the UK, the yield on a 1 month government bond is just about 0.3 percent (see Chart 1) – pretty close to zero (its zero in the US, even slightly negative in Germany, but somewhat higher in the Lucky Country). With UK inflation at about 1.2 percent, the inflation adjusted real return in the UK is minus 0.9 percent (i.e. = 0.3-1.2).
Source: Financial Times
That real interest rates should be so low is not really all that surprising. Of course the current poor performance of the global economy and the monetary policy response to that is one reason for low interest rates, but it is not the only one. Real interest rates have been falling for a long time – long before the Great Recession and the current level partly reflects that long-run trend.
Figure 2 shows estimates by Thomas Laubach and John C. Williams of the US Federal Reserve for what we could term a cyclically adjusted real interest rate (also referred to as the natural rate), meaning the one that we would have if the economy wasn’t in a recession (or a boom). Their estimates indicate that the real rate has been declining more or less since the late 1960’s and has recently gone to close to zero. TH poked around and found some other research on the factors behind this “secular” decline. This research suggests that the decline from the early 1990’s to around 2004, was largely due to weakening of investment demand. According to this hypothesis, firms in the 1970s were busy investing in machinery to equip the baby-boomers that were starting to enter the labour market at the time, so interest rates were high at the time. But as that cohort has aged, the need for investment diminished causing investment demand and interest rates to fall. Now, as the baby boomers retire, investment demand has weakened even more, adding to the downward pressure. Other factors, such as the increase in savings supply from China that started 2004, have likely contributed to the downward pressure too. Interestingly, some findings suggest that easy credit policies in the 1990’s and early 2000’s may have helped to prevent interest rates from falling by keeping household consumption high and savings low, so it is likely that when easy credit came to an end with the crisis, the real interest rate fell.
Some of those forces that have driven real interest rates down — especially the aging population — are likely to continue for some time to come. And while TH has some difficulty believing that the inflation adjusted return on his investments will be negative, it is possible (especially once you adjust for risk) and it may have further to go.
The next post will try to think through some of the implications of the slow but continual decline in the real interest rates. But, in the meantime …