Thursday, October 22, 2015

Low interest rates are here to stay

Noah Smith

22 Oct 2015

Why are interest rates so low? For macroeconomists, this is one of the Big Questions in the world today.

Government bond rates are at or near record lows. So are corporate bond rates, including junk bonds. Even the cost of equity capital is at or near an all-time low for most businesses. Whether you're a government, a big corporation or a tiny start-up, it has never been cheaper to obtain capital.

Interest rates have been in decline since the early 1980s. For a while, that looked like a simple regression to the mean. The early 1980s saw central banks tighten a lot, driving up rates in an effort to rein in inflation. But the decline during the past 15 years or so - and especially since the financial crisis - goes way beyond a simple normalisation. Something unusual is happening.

That's worrying for macroeconomists, because it means old theories may be wrong. It's also worrying for central bankers because it constrains their actions (nominal interest rates can't be pushed below zero) even as it increases the uncertainty under which they are forced to make their decisions.

So why are rates so bizarrely low? Interest rates are set in markets, where borrowers meet lenders (broadly defined). Any explanation for falling rates must involve an increased desire to lend, a decreased desire to borrow, or both. One common theory is that central banks are responsible. This makes sense to most people, since we all hear that the US Federal Reserve, or the Bank of Japan, has a policy of holding interest rates near zero. But just because central banks are setting their rate targets at zero doesn't mean they have to work very hard to achieve that target.

There are reasons to think that central banks are not the big driver of low rates. First, it isn't just nominal rates that are historically low, but real inflation-adjusted rates too. Most economists believe real interest rates can't be affected by monetary policy for very long.

Second, most economists think that if central banks are holding rates below what private markets want, we should be seeing high inflation. We're not. And finally, the end of the Fed's bond-buying programme of quantitative easing seemed to have only a small effect.

So are low rates being driven by a savings glut? That was the famous hypothesis of former Fed chairman Ben Bernanke in 2005. The idea was that developing countries - for example, China - were saving more than they were investing, and that the excess capital was flowing into the United States, and lowering borrowing costs. Since the financial crisis, savings rates have risen in the US as well - households are squirrelling away more, and corporations are famously hoarding cash. The savings glut might have gone global.

Another reason for low rates - an underrated reason, I suspect - could come from the demand side of the equation. The desire to borrow money clearly seems low across the world. Households in the US and other countries that suffered a big housing bust have large overhangs of debt, and the crash showed them that debt was more dangerous than they had realised. Companies in Europe are clearly reluctant to borrow to invest, given the running political uncertainty surrounding the euro and the sovereign debts of countries such as Greece. That probably applies to Japan as well.

In addition, these rich countries have steeply declining populations, and shrinking domestic markets discourage companies from expanding. As for US companies, they may be holding back investment because of fears of weakness in export markets. China is slowing, and with it many other developing countries.

Another factor may be the recent wave of technological disruptions that make it harder for firms to plan ahead. Big investments require big bets, and in an era of massive disruption, no one knows which bets to place. And even as disruption is increasing, overall productivity is slowing.

So what will stem the tide of low interest rates? I wouldn't count on central banks to do the job. As long as private markets keep pushing rates down, central bankers are not going to risk causing recessions by trying to raise them. Nor are firms going to suddenly become brave and bold around the world.

There are some factors that may stop the downward slide. American households will eventually work off their debt overhang - already, the housing market is recovering. At the same time, China is also rebalancing towards a more consumption-based economy. That should do a bit to drain the savings glut, at least when China's current sharp slowdown has run its course.

But long-term trends - declining global population growth and continued technological disruption - point to a very long period of low interest rates.


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