One of the most striking features of today’s macroeconomic environment is the exceptionally low level of both nominal and real interest rates worldwide, especially in advanced economies. The downward trend in interest rates began in the early 1980s and coincided with a strong and sustained reduction in inflation and a period of low macroeconomic volatility (Chart 1). The decline in interest rates accelerated after the global financial crisis of 2007-2008, when central banks aggressively cut short-term interest rates and monetary policy became highly supportive.

There are three key issues in the ongoing debate among academics and analysts: 1. What are the driving forces behind the downward trend in global interest rates? 2. Will the low interest rate environment persist (and for how long)? 3. Will central banks continue to use unconventional monetary policy measures in the future (and why)?

As the debate continues, there are no definitive answers to these questions. In my brief remarks, I will attempt to summarize the different views expressed in this discussion, highlighting the role of the so-called “natural rate of interest” in shaping the macroeconomic environment and the “new normal” of monetary policy. I will argue that the low interest rate environment is likely to persist for a longer period. Central banks will continue to use unconventional tools in the future, primarily because the effective lower bound will remain binding. Finally, central banks will need to consider the benefits for financial stability of maintaining their balance sheets at sufficiently high levels.

The Long-Term Decline of the “Natural” Interest Rate (r*)

Much of the debate surrounding the long-term decline in global interest rates focuses on the so-called “natural” equilibrium interest rate. The concept of the natural rate of interest dates back to Knut Wicksell, who introduced it in 1898 in his book Interest and Prices as a restatement of the Quantity Theory of Money to explain inflation in an economy with credit expansion.

According to economic theory, the real equilibrium interest rate, r* — equal to the marginal product of capital, f ‘(k) — is related to the potential growth of the economy and individuals’ preferences, as reflected in the discount rate. The discount rate (z) reflects the required real interest rate that investors seek to replace present consumption with future consumption. Potential growth itself is due to the long-term increase in productivity (g) and the rate of labor force growth (n):

The equilibrium interest rate is not observable and must be estimated using statistical filters or econometric methods based on theoretical models. Chart 2 presents estimates of the equilibrium interest rate by Holston, Laubach, and Williams (2017) for the US, Canada, the Eurozone, and the UK. The equilibrium interest rate appears to have followed a downward trend over the past fifty or so years. The Great Recession of 2008-09 seems to have exacerbated this downward trend, particularly in the US and the Eurozone. The equilibrium interest rate fell from an average of 3.5% in the 1960s and 1970s in the four economies to 2.5% during 1980-2007, and further to 1% after 2008.

How the Decline of r* Affects Monetary Policy

The equilibrium interest rate acts as an anchor in a monetary economy. If the long-run neutrality of money holds, according to the Quantity Theory of Money, then monetary policy follows the trend of r*. Central bankers clearly recognize the role of r* as a benchmark for monetary policy:

“The best strategy for the Fed that I can think of is to set interest rates at a level consistent with… the (today’s low) equilibrium interest rate.” (Ben Bernanke, former Chairman of the Fed, 2015)

“The role of monetary policy should therefore be to guide policy and market interest rates to this equilibrium rate.” (Vitor Constancio, Vice President of the ECB, June 15, 2016)

“Our understanding of the economy and monetary policy is based on the concept of the natural interest rate… which balances monetary policy so that it is neither accommodative nor restrictive regarding growth and inflation.” (John Williams, President of the FRB of San Francisco, August 15, 2016).

These views from monetary policymakers are based on the Taylor rule, which provides a fairly good ex post description of how the central bank sets the nominal policy rate:

i = r* + π* + α(π – π*) + β(y – y*) (2)

In equilibrium, when the output gap is zero, and inflation equals the central bank’s target, the nominal policy rate equals the sum of the equilibrium interest rate and the inflation target. From this analysis, it follows that if the equilibrium interest rate has indeed declined from an average of 3% during the 1960s-2007 period to less than 1% after 2008, and the central bank maintains its inflation target at 2%, the nominal short-term interest rate will be at equilibrium at 3%, not 5% as it was in the past.

Thus, if the new normal is characterized by a lower equilibrium interest rate, nominal interest rates will more frequently be at the effective lower bound, central banks will have less room to stimulate the economy in times of recession, and the economic recovery will be slower. This will make the more frequent use of unconventional monetary policy tools necessary, in combination with conventional tools such as interest rates.

Key factors for the reduction in interest rates

The key factors for the reduction in interest rates, according to the academic literature, are centered around two main approaches: the real/structural approach and the financial cycle approach.

1. Real/Structural Approach:
   The first variation of this approach is based on the neoclassical growth model, according to which the real equilibrium interest rate is determined by the rate of potential growth and consumer preferences. The reduction in the real equilibrium interest rate is seen as a result of the slowdown in productivity and the aging of the population (Gordon 2015, 2016).
   The second variation focuses on the imbalance between savings and investment. Structural changes in the supply of savings and the demand for investment led to a reduction in the real equilibrium interest rate. These explanations focus on global factors such as (a) the “global savings glut” due to higher savings rates in emerging markets (Bernanke 2005), (b) the decline in the relative price of capital goods, which led to a reduction in overall investment relative to savings (Rachel and Smith 2015), and (c) the expansion of the services sector, which is less capital-intensive than the manufacturing sector, thus requiring fewer investments in the overall economy to produce the same output (Summers 2014).
2. Financial Cycle Approach:
   The second approach is linked to the accumulation of debt during the global financial cycle and the collapse of a “debt super-cycle” (Rogoff 2015, Lo and Rogoff 2015). The narrative of this approach is as follows: due to the inherent instability of financial markets, poor risk management, and insufficient regulation, during periods of economic boom, borrowing and leverage increase. When the economy enters a recession, credit constraints become binding, the private sector, and potentially governments, find themselves unable to service their debt, leading to de-leveraging. The lack of credit and the slow process of de-leveraging intensify the recession and slow down the recovery after financial crises (Reinhart and Rogoff 2009). According to this interpretation, the global reduction in interest rates over the past decade can be seen as a result of the global financial crisis of 2007-2008 and the collapse of a “debt super-cycle.”

A second variation of the financial cycle approach claims that the fall in the equilibrium interest rate after the major financial crisis of 2007-2008 is linked to the lack of safe assets, as the financial crisis destroyed a significant portion of the supply of AAA-rated safe securities. On the other hand, demand for safe assets increased not only due to the general rise in risk aversion after the crisis but also due to changes in the regulatory framework for banks and the increased need for safe and liquid assets to be used as collateral in repurchase agreements (repos). This led to the emergence of a deflationary “safety trap,” resulting in a reduction in real zero-risk interest rates (Caballero and Farhi 2018).

According to Caballero and Farhi (2018), the global supply of safe assets fell from $20 trillion in 2007 to $12 trillion in 2011. Barclays (2012) estimates that the 2007-2008 crisis and the subsequent debt crisis in the eurozone from 2010-2012 destroyed about 50% of the supply of safe assets. According to Del Negro et al. (2017), the reduction in the equilibrium interest rate primarily reflects the increase in the premium for safety and liquidity since the late 1990s (the so-called “convenience yield”) and, to a lesser extent, the reduction in the potential growth rate of the economy. The lack of safe securities in the economy leads to a reduction in equilibrium interest rates because investors are willing to accept lower returns in exchange for higher safety and liquidity (Krishnamurthy and Vissing-Jorgensen 2012).

Both of the above approaches reach different conclusions regarding the prospects for maintaining a low-interest-rate environment in the future. The real/structural approach emphasizes the role of structural factors, such as technology, demographic trends, and preferences, and therefore predicts that real interest rates will remain at low levels for a long time. In contrast, the financial cycle approach predicts that the phenomenon of low interest rates will not last forever. Once leverage and borrowing subside, economic growth is likely to accelerate gradually, pushing real interest rates to higher levels. The two approaches also differ in terms of their implications for monetary policy.

Quantitative Easing as a Global Factor of Interest Rates

Without dismissing the role of real and financial factors, one could argue that the use of unconventional monetary policy over the past decade has also contributed to the reduction of global interest rates. Indeed, the size of the total balance sheet of the four major central banks (Fed, ECB, BoJ, BoE) quadrupled from $4 trillion in 2007 to approximately $16 trillion by the end of 2016. This amounts to 45% of the combined GDP of the four countries/economic areas, compared to about 10% of GDP in 2007 (Chart 3).

In the context of quantitative easing (QE) strategies, central banks purchased long-term bonds in exchange for liquidity, i.e., increasing the reserves of commercial banks. Since long-term bonds and reserves are imperfect substitutes, QE reduced long-term interest rates and boosted demand, thereby supporting economic recovery and limiting deflationary pressures. As global capital markets are highly integrated, QE had significant international effects, particularly in emerging markets, where large capital inflows and currency appreciations were observed (MacDonald 2017).

Research at the Bank of Greece shows that quantitative easing by the major central banks has acted as a global factor, driving global government bond yields lower. Specifically, the increase in the size of the balance sheet of the four major central banks explains approximately 90% of the common variance of global bond yields during the period 2009-2017 (Malliaropulos and Migiakis 2019). It is estimated that quantitative easing has led to a permanent reduction in government bond yields worldwide, ranging from 250 basis points (bps) for AAA bonds to 330 bps for B-rated bonds. One interpretation of this result is that the central banks’ bond purchases reduce the net supply of government bonds available to the private sector, leading to a permanent reduction in yields. A similar argument has recently been made by Benoît Cœuré (2019) regarding the impact of the ECB’s asset reinvestment program on government bond yields in the Eurozone.

The Effects of Negative Interest Rates

Some central banks, including the ECB and the central banks of Denmark, Switzerland, Sweden, and Japan, have experimented with negative policy interest rates in recent years. The ECB introduced negative interest rates on its deposit facility in June 2014. The negative nominal interest rate on the deposit facility means that commercial banks are required to pay fees for holding their excess reserves at the central bank. The aim of introducing negative interest rates was to encourage banks to provide credit to the real economy instead of holding their liquidity at the central bank. However, the role of negative interest rates is highly debated among economists and central bankers because they act as a tax on the banking system and can thus reduce credit expansion. Furthermore, below a certain threshold, the so-called “reversal rate,” negative policy rates can become counterproductive, as they may affect the profitability of banks since they cannot easily pass negative nominal rates onto depositors. Finally, they may lead depositors to withdraw funds from the banking system and increase their use of cash in transactions.

Effects on Depositors

According to recent research by the European Central Bank (ECB), interest rates are negative for approximately 5% of total deposits and about 20% of corporate deposits on average in the euro area (Altavilla et al. (2019)). However, in Germany, it is estimated that around 15% of total deposits and about 50% of corporate deposits have negative interest rates, much higher percentages than the euro area average. One possible explanation is that German banks have high levels of excess liquidity, as international investors consider German government bonds a safe haven. Consequently, due to capital inflows into the German economy, German banks are less reliant on customer deposits and, therefore, can more easily pass on negative interest rates to their clients.

Although negative nominal interest rates are a new phenomenon, real interest rates on bank deposits have been negative many times in the past. Specifically, the real return on household deposits was negative for most of the past 50 years in many countries of the euro area.

Chart 4 shows the real interest rate of three-month household savings deposits in German banks, based on data from Deutsche Bundesbank. The chart reveals that real interest rates on deposits were negative for more than ten years in the 1970s, as well as during the first half of the 1990s and in the early years of this millennium. The average real deposit rate has been -0.77% since the introduction of negative interest rate policy in June 2014. It is worth mentioning that real deposit rates in Germany were even lower, at an average of -1%, during the twelve years from mid-1971 to mid-1982.

These observations suggest that both in periods of high inflation and in periods of very low inflation, real deposit rates can be negative. The difference is that, due to the “money illusion,” depositors are more concerned with the nominal rather than the real return on their savings.

Nevertheless, the focus of the debate on negative interest rates for depositors is quite limited, as it overlooks that evaluating the net effect of a low-interest-rate environment on depositors requires a full cost-benefit analysis. For example, the same depositor who faces low or negative interest rates on their deposits might simultaneously benefit from lower interest payments on their mortgage or consumer loan. In conclusion, the net effect of a low-interest-rate environment on household finances depends on the household’s overall economic position.

Impact on Banks

Critics of the negative interest rate policy often accuse the ECB of imposing negative rates on deposit facilitation, which burdens the already low profitability of banks in the euro area. In general, the reduction of the spread between long-term and short-term interest rates due to central bank bond purchases can indeed squeeze commercial banks’ net interest margins and put pressure on their profitability. This is because banks borrow short-term and lend long-term. Therefore, the flattening of the yield curve may negatively affect their profits and reduce their willingness to provide credit to the economy.

However, at the same time, the policy of quantitative easing has had a positive effect on the economy and, consequently, on bank profits, as banks faced greater demand for loans. Furthermore, lower interest rates result in fewer loan defaults, leading to lower losses for banks. Overall, based on available data, it is unclear whether the net effect of quantitative easing on bank profitability is negative.

It is worth noting that, in order to mitigate the impact of negative rates on banks’ profits, the ECB has recently introduced a system that exempts banks from the deposit facility rate for deposits at the central bank up to six times the value of their required minimum reserves. This measure ensures that the recent reduction of the deposit facility rate to -0.50% (from -0.40%) will not negatively affect banks’ profitability.

Monetary Policy in the “New Normal”

Looking ahead, a key question is whether and to what extent central banks will revise their monetary policy framework to include, for example, financial stability targets, adopt a higher inflation target to increase the central bank’s policy space, target a price level instead of inflation, or even abolish cash usage. These proposals certainly have some benefits but need to be carefully assessed, as they could negatively affect the credibility of central banks and lead to destabilization of inflation expectations.

Central banks will continue to use their balance sheet size as a monetary policy tool and provide forward guidance to markets regarding the expected path of interest rates. There are many theoretical and practical reasons for this. First, the effective lower bound will remain a binding constraint on interest rate policy in a low inflation-low interest rate environment.

Second, there are strong arguments for central banks to maintain sufficiently large balance sheets. As Greenwood, Hanson, and Stein (2016) argue, the central bank can continue to control short-term interest rates, regardless of the size of commercial banks’ reserves and its own balance sheet, by paying interest on bank reserves and offering reverse repurchase agreements. Additionally, liquidity is desirable, and liquidity creation enhances economic stability, especially during periods of heightened demand for safe assets.

Third, as central bank asset purchases have led to a permanent reduction in government bond yields worldwide (Malliaropulos and Migiakis 2019), any reduction in the size of central banks’ portfolios could trigger a significant rise in long-term interest rates, leading to tighter financial conditions with serious consequences for global economic activity and financial stability.

Short-Term Challenges of Monetary Policy

In the short term, the main challenge for central banks is dealing with a potential recession. The global economy is currently in a phase of slowdown due to trade protectionism and prolonged uncertainty about trade policy, which is impacting investments. A particular feature of sluggish growth in 2019 is the sharp slowdown in the manufacturing sector and global trade. The slowdown in 2019 was uniform across economies, but it was particularly pronounced in the euro area, especially in member states with a strong export orientation, as well as in some large emerging economies.

A complicating factor in the event of further deterioration in the global economy is the limited room for counter-cyclical monetary policy, as central bank interest rates in advanced economies are generally very low or even negative. Since monetary policy alone cannot bear the burden of defending against a new crisis, fiscal policy should play a more active role in countries with sufficient fiscal space, acting complementarily to monetary easing.

The extremely low cost of servicing public debt provides an opportunity for public investments in infrastructure, energy, and new technologies, which can help drive the digital transformation of economies and address climate change. On the other hand, countries with high public debt should continue fiscal consolidation, but with a policy mix that is more supportive of economic growth, focusing on investments and lower taxation.

Regarding monetary policy, central banks are expected to increase the use of unconventional measures, such as large-scale asset purchases, market guidance, and possibly negative interest rates, to support economic activity. Financial stability will remain at the core of macroprudential policy, although monetary authorities will continue to consider financial stability issues when formulating monetary policy.

In conclusion, I would like to raise two issues in the discussion about the future of monetary policy. First, regarding the size of the central bank’s balance sheet, regardless of the “optimal size” — which is unknown and probably immeasurable — there are legal and economic constraints on the expansion of central bank balance sheets. From a legal perspective, exceeding a certain threshold in holding bonds would make the central bank a minority creditor, capable of opposing the restructuring of public debt based on a collective action clause (Martinelli, 2016). However, from an economic perspective, a large central bank balance sheet creates distortions in financial markets, as financial prices no longer reflect fundamental variables but rather the expected actions of the central bank. Finally, by assuming the role of the Ministry of Finance in managing public debt, central banks jeopardize their political independence.

Second, regarding the scope of monetary policy in a potential global economic recession, I would like to pose the following question: Undoubtedly, the room for further lowering intervention rates is small, as rates are already very low or negative in many countries. However, the room for implementing unconventional measures, such as asset purchases, is likely larger than many analysts believe. This is because, in the event of a global recession, bond yields will rise as (a) risk premiums in markets will increase due to the recession and the heightened risk aversion of investors, and (b) the supply of safe securities will rise as governments increase fiscal deficits to support the economy. As a result, the yields on many bonds that are currently trading with negative yields at maturity will return to positive levels. This will expand the pool of eligible bonds for monetary policy purposes, allowing central banks to engage in new asset purchases to reduce long-term interest rates.

In conclusion, the arsenal of central banks is likely to grow in times of recession and financial market turmoil, in contrast to a static view of the state of the economy and markets. Just as in 2008 no one could predict the extent of the forthcoming monetary policy easing, it is difficult today to safely assess the scope of central bank interventions in the event of a new global recession.

References:

Altavilla, C., Burlon, L., Giannetti, M. and Holton, S. (2019): Is there a zero lower bound? The effects of negative policy rates on banks and firms. ECB Working Paper No. 2289, June 2019.

Barclays (2012): Equity gilt study.

Bernanke, B. (2005): The global savings glut and the U.S. current account deficit. Sandridge Lecture. http://www.federalreserve.gov/boarddocs/speeches/2005/200503102/

Caballero, R.J. and Farhi, E., (2018): The safety trap. Review of Economic Studies, pp. 223-74.

Cœuré, B. (2019): The effects of APP reinvestments on euro area bond markets. Closing remarks at the ECB’s Bond Market Contact Group meeting, 12 June 2019. https://www.ecb.europa.eu/press/key/date/2019/html/ecb.sp190612_1~1a3bede969.en.html

Del Negro, M, Giannone, D. Giannoni, M and Tambalotti, A., (2017): Safety, liquidity, and the natural rate of interest. Brookings Papers on Economic Activity (Spring 2017), pp. 235-94.

Greenwood, R. Hanson, S.G. and Stein, J.C. (2016): The Federal Reserve’s balance sheet as a financial tool. Paper presented at the 2016 Jackson Hole Symposium of the Federal Reserve Bank of Kansas City.

Krishnamurthy, A. and Vissing-Jorgensen, A., (2012): The aggregate demand for treasury debt. Journal of Political Economy 120(2), pp. 233-67.

Lo, S. and Rogoff, K. (2015): Secular stagnation, debt overhang and other rationales for sluggish growth, six years on. BIS Working Paper 482. http://www.bis.org/publ/work482.htm.

Malliaropulos, D. and Migiakis, P. (2019): Unconventional monetary policy and sovereign bond yields: A global perspective. Bank of Greece Working Paper No. 253.

MacDonald, M. (2017): International capital market frictions and spillovers from quantitative easing. Journal of International Money and Finance 70, pp. 135-156.

Martinelli, T. (2016): Euro CAC and the existing rules on sovereign debt restructuring in the euro area: An appraisal four years after the Greek debt swap. Ademu Working Paper Series No 2016/043.

Rachel, L. and Smith, T.D. (2015): Secular drivers of the global real interest rate. Bank of England Staff Working Paper No. 571.

Reinhart, C. and Rogoff, K. (2009): This time is different: Eight centuries of financial folly. Princeton University Press.

Rogoff, R. (2015): Debt supercycle, not secular stagnation, 22 April 2015. www.voxeu.org/article/debtsupercycle-not-secular-stagnation

Summers, L. (2014): US economic prospects: Secular stagnation, hysteresis, and the zero lower bound. Business Economics, vol. 49(2), pp. 65-73.

Williams, J.C. (2016): Monetary policy in a low R-star world. FRBSF Economic Letter 2016-23, August 15, 2016.

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