The natural rate in the advanced economies may fall even further

By Atanas Hristov and Timo Wollmershäuser
Ifo Institute​, Munich

Short-term and long-term interest rates are very low by historical standards both in the Eurozone and in other advanced economies. Low interest rates are not a temporary phenomenon, but part of a longer-term tendency—a declining trend that started to take shape prior to the recent global financial crisis and the worldwide recession that followed. Figure 1 shows that ten-year aggregated government bond yields in the Eurozone reached a peak in the early 1980s that was unmatched in the preceding decade, and have been declining with some interruptions ever since. Fluctuations in inflation, as shown in Figure 1, only partly explain this pattern. Since mid-2014, in view of the far more moderate than expected economic dynamic and decreasing inflation expectations, several central banks, including the European Central Bank (ECB) and the Bank of Japan, have implemented negative interest rates. This longer-term tendency of declining interest rates has provoked the worry that rates needed to support output at its potential, especially in the Eurozone and in Japan, may remain low, even negative, for an extended period of time. On top of that, given that it might be counterproductive for central banks to excessively lower the target for their benchmark short-term interest rates further into negative territory (Skidelsky, 2016), the rates that may maintain full employment might be impossible to achieve. According to many economists, the key to understand the current situation lies in the concept of ‘secular stagnation’ (Summers, 2014). In this view, many advanced economies suffer from an imbalance resulting from a lower willingness to invest and a higher propensity to save. The discrepancy between excessive saving unmatched with sufficient investment acts as a drag on demand and lowers real interest rates.

While central banks steer the short-term nominal interest rates, in the long run rates are beyond the control of monetary policy (Bernanke, 2015). All other things being equal, a monetary policy of lowering short-term rates tends to boost economic activity and, in turn, lift inflation and inflation expectations; and vice versa. The level at which rates must settle in due course to keep inflation stable over an extended period of time and the economy at maximum employment is determined by the economy’s underlying characteristics. More specifically, a long list of factors, including households’ preferences for present as opposed to future consumption and the economy’s potential for growth, establish the real (that is, inflation-adjusted) interest rate. According to a concept introduced in 1898 by Knut Wicksell, this rate is known as the natural, equilibrium, or Wicksellian rate of interest.

Monetary policy has played some role, rather involuntarily, for the current imbalance between propensity to save and propensity to invest. According to estimates by Hristov (2016), the natural real rate of interest in the Eurozone has gradually declined over the past 35 years and is currently very low by historical comparison. For central bankers the goal is to direct interest rates so that they match up with the natural rate. Thus, despite the fact that the ECB steered short-term rates into negative territory in mid-2014, the stance of monetary policy has remained tight since then. This is one of the reasons why employment in the Eurozone has chronically failed to reach full employment and inflation is stuck at levels far below the two percent target.

There are many other confounding factors that led to the sharp fall in the natural rate following the recent financial crisis. Some of these factors include the collapse of financial intermediation which increased uncertainty and in turn pushed precautionary saving even higher. The fall is also partially a result from persistent headwinds from the crisis, including deleveraging by households, tighter underwriting standards, etc.

Given the complexity of the issue, the uncertainty related to any estimate of the natural rate and the bounty of determining factors at play, it is extremely hard to predict where the natural rate will lie in the future. It is important to note that although many of the explanatory factors that have been put forward are going to slowly fade away, many others are going to be present even in the next decade. The trend towards a decline in the natural rate can partly be blamed on global factors, such as fewer investment opportunities in advanced economies as well as a higher propensity to save in emerging markets (Bernanke, 2007). On the other hand, it could also reflect permanently lower growth rates in productivity (Gordon, 2015). Saving has been on the rise in many developed countries also due to the relative low growth of those population segments that have a higher propensity to save. This has been primarily caused by an increase in life expectancy, which has not been paralleled by a proportional rise in the retirement age. Probably one of the most important future determinant of global saving is the consumption profile in the emerging economies, especially in Asia. If the relation between saving and GDP remains stable, and without a sizeable reduction in GDP growth, if anything, the natural rate in the advanced economies may fall even further.

References

Bernanke, Ben S. 2007. “Global Imbalances: Recent Developments and Prospects.” Bundesbank Lecture, September 11.

Bernanke, Ben S. 2015. “Why Are Interest Rates So Low?” Ben Bernanke’s Blog, Brookings Institution, March 30.

Gordon, Robert G. 2015. “Secular Stagnation: A Supply-Side View.” American Economic Review: Papers & Proceedings 105(5): pp. 54–59.

Hristov, Atanas. 2016. "Measuring the Natural Rate of Interest in the Eurozone: A DSGE Perspective." CESifo Forum 17 (1), pp. 86-91.

Skidelsky, Robert. 2016. “The False Promise of Negative Interest Rates.” Project Syndicate Blog, May 24.

Smets, Frank, and Rafael Wouters. 2007. “Shocks and Frictions in US Business Cycles: A Bayesian DSGE Approach.” American Economic Review 97 (3): pp. 586–606.

Summers, Lawrence H. 2014. “U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound.” Business Economics, 49(2), pp. 65–73.

Wicksell, Knut. 1898. “Interest and Prices.” London: Macmillan.