Downward Trends In Interest Rates

This summary addresses key patterns of low interest rates and explains different academic views regarding the causes of their downward trend.  Reasons presented below, include secular stagnation, lack of demand, inefficient supply, demographics and debt overhang.

 

Patterns

The fall in interest rates has been associated with the global financial crisis and the decline of yields. The argument is that low interest rates are an outcome of low inflation.  Although inflation has played an important role in keeping nominal interest rates low, it cannot be considered the only reason, since there is also a downward trend in real interest rates. Evidence can be found in the 10-year government bond of advanced economies (US, UK, Germany).  The downward trend in government bonds signals that low rates is not just a simple reflection of low inflation; there are additional structural reasons associated to that trend.

Another reason often cited is weak economic activity, since business cycles are associated to interest rates fluctuations. A recession is related to an interest rate cut; and an economic expansion, to a hike. A formal assessment of interest rates indicates that the rate can be low mainly because of temporary business cycles in the economy that brings economic activity below the equilibrium level. For this reason, it is important to identify the natural interest rate, which is something unobservable.

Holston, Laubach and Williams (2016) have estimated the natural rate of interest, the rate that would have prevailed if interest rates where fully flexible[1]. By using a standard New-Keynesian model, they statistically extract the natural rate by using Kalman’s filter. They find a large decline in GDP growth and natural rates over the past 25 years in the advanced economies. Interestingly, the decline in the yield also appears beyond safe assets, something that signals lower growth potential and lower returns in all asset classes. Consequently, there is clear evidence of a reduction in interest rates that is associated with different causes, like secular stagnation, lack of demand, inefficient supply, demographics and debt overhang.

 

1.Demand Side – Secular Stagnation

Another cause for the reduction in interest rates is associated with the lack of aggregate demand. This is related to the term ‘secular stagnation’; and the insufficient aggregate demand that followed the Great Depression in 1930.Countries with savings rates demanded more safe assets. In that way, high savings rates act as collateral, a “precautionary” measure to maintain economic activity during sluggish periods of growth to fund investments. This is the reason that these types of measures are likely to be followed by higher risk premiums.

Based on that view, a tightening in borrowing constraints reduces interest rates. Once the economy goes through the deleveraging cycle, interest rates increase, returning to their ‘normal’ value. This is a reflection of the discount factor that determines the level of the interest rate.Eggertson and Mehrotra (2014), used an OLG model with three different stages of life (young-middle-old), and financial constraints, to argue that interest rates are not given by the discount rate, but are rather determined by the distribution of income between savers and borrowers. Accordingly, they provide evidence that low interest rates are due to lack of demand.

 

2.Demographics

Moreover, one must also consider the impact of demographics, and the substantial changes in the structure of the population since the 1960’s to understand the downward trend on the exchange rates. Gagnon, Johannsen, Lopez-Salido (2016) suggest that the global shift in demographics have rendered central banks powerless to raise long-term interest rates.

In particular, they find that the combination of greater longevity and reduced birth rates in the Western countries, account for 1.25% decline is the natural rate of real interest rate since 1980’s. Basically, the idea is that people across the world save more during their working years (25 to 60 years old) and consume later in their retirement, even more in the last period of their life by spending on health care treatment.

Initially, in the presence of abundant labour and capital stock, interest rates are high. This prompts consumers to usually buy bonds when they are working – through pension contributions from their salaries which have a downward pressure on the yields. Then as the large cohort goes into retirement period, we are left with a high capital labor ratio and low interest rates. During that period, people tend to consume more and save less, something that has an upward push to yields. This finding implies that demographics can be a major reason for a downward trend in interest rates and decline in economic growth.

 

3.Deleveraging

In addition, another cause for the decline in the interest rates is related to the deleveraging cycle. One of the legacies of the 2008 financial crisis is the high level of debt, that constraints growth and creates additional pressure on financial institutions. The idea of deleveraging is similar to the concept of secular stagnation with one main difference. In secular stagnation, the economy “stagnates”, it is a static state that an economy can’t get out. On the other hand, deleveraging is a more dynamic process that you can breakthrough.  Lo and Rogoff (2015) argue that the current economic period is not a case of secular stagnation, but debt overhang. Focusing on the US market, they found that households have successfully reduced their debt after the financial crisis. However, this is not the case in other continents of the world (Euro-area), where debt levels remain relatively high. Therefore, they argue that the main reason that interest rates are still low is that the world’s economy is still into the deleveraging cycle.

 

4.Supply Side

Another reason is related to the supply side of the economy. Based on that, Gordon (2015) argues that the revolution that boosted productivity in the 90’s – 00’s was temporary. New digital technologies cannot match the surge of productivity from past inventions such as electricity, petroleum etc. Gordon argues that the economic slowdown is a result of a sharp decline in growth rates of aggregate hours and output. Consequently, the decline in productivity levels is associated to lower growth rate and lower investments that conclude to lower real interest rates.

 

5.Other: Savings Glut – Liquidity Trap

Other explanations for low interest rates are related to the theory of “savings glut” by Ben Bernanke (2005), as well as the theory of a liquidity trap by Paul Krugman (1998).  The first one suggests that a global excess of desired saving over desired investment is a major contributor to low-interest rates. In other words, low-interest rates and increasing capital flows to the US financial market helped to elevate asset prices and appreciated the dollar. The appreciation of the currency gave greater purchasing power to the US consumers that rushed to buy cheaper goods from abroad, by boosting US imports. As a result, the trading deficit increased due to an excess of over-consumption which was fueled by financial inflows coming from abroad.  This mechanism implied a substantial downward pressure on interest rates.

The second one argues that demand is anemic, because short term interest rates fall short of the necessary employment level of the economy. In that way, investors should make a tradeoff between liquidity and yield. They can hold cash that yields to zero or limit their holdings since there is an opportunity cost of lost earnings. Theoretically, increasing money supply reduces interest rates, however, at the Zero Lower Bound there is no liquidity cost. In other words, liquidity injections fail to decrease rates and make monetary policy less effective.