How Long Can Interest Rates Stay Low?

When a central bank lifts interest rate targets by Zero.5% it expects households and firms to respond. In a crisis, the state target may fall through 3% in order to shock the economic climate into a positive response. These movements of interest rates through the central bank are an important tool of macroeconomic adjustment.

They will also be relative to the longer term, or regular rate of interest in the economy. What is fascinating now is that rates happen to be low for quite a long time recommending the natural rate of interest in the economy has fallen permanently.

A recent study paper from the Bank associated with England suggests that the global neutral interest rate may settle at or below 1%. To put this in context, the document suggests that rate was about 5.5% in the 1980s (indeed, that is real, so adjusted for inflation).

Central banks can get into a tizz about this because it provides them less room to cut prices to stimulate the economy. It gives the bankers much less room to cut interest rates in a crisis.

The reasons for the fall are broadly that saving has tended to increase and investment to fall; more money can be obtained but fewer people want to borrow, thus driving down rates. The authors from the Bank of England document argue the trends won’t change abruptly so we can get low rates for a long time.

They suggest cost savings have tended to increase partly for demographic reasons, because of rising inequality, and from a wish by Asian governments to maintain a financial buffer. The main demographic reason has not been ageing, but a decline in the addiction ratio: as birth prices have fallen, the proportion of people who were not of working age has fallen from 50% to 42% over the last 30 years. With fewer children, people have had the opportunity to save more.

Piketty and others possess pointed out the increase in within-country inequality over the last few decades, and since richer people save more than poor people, this too has tended to boost savings.

At the same time, the authors argue that expense has fallen for three main reasons. The most important is the fall within the price of capital equipment which has meant that a given increase in output can now be obtained more inexpensively (with a lower investment invest).

Investment by government has also fallen slowly but surely over recent years, albeit with some uptick in response to the global financial crisis. It is less clear why this has happened but I suspect it is because government revenue growth is limited by sensitivity around taxes, and government expenditure is increasingly directed towards transfer payments. Investment also seems to have fallen since it appears to have become relatively more risky – the return on funds has fallen but not up to the risk free rate – lowering the inclination of firms to take a position.

What does it mean for you and I? Broadly, we face a world, which advantages investors and downsides savers. The returns upon our investments in secure assets will be low as well as investors are likely to take on additional risks in order to boost returns. This makes it hard for Australian traders since banks and miners dominate our exchange: the low interest rate environment is not good for banking institutions, and there is no clear end in view to the commodity price recession.

As voters, we should be less concerned about public debt than we were. The case for policy changes, which stimulate growth has increased, and elevated government investment in productive property is strengthened.

Risk on? Interest rates could stay low for decades is republished with permission in the Conversation