Wednesday, November 26, 2014

How Long for Low Rates?

CAMBRIDGE – How long can today’s record-low, major-currency interest rates persist? Ten-year interest rates in the United States, the United Kingdom, and Germany have all been hovering around the once unthinkable 1.5% mark. In Japan, the ten-year rate has drifted to below 0.8%. Global investors are apparently willing to accept these extraordinarily low rates, even though they do not appear to compensate for expected inflation. Indeed, the rate on inflation-adjusted US Treasury bills (so-called “TIPS”) is now negative up to 15 years.

Is this extraordinary situation stable? In the very near term, certainly; indeed, interest rates could still fall further. Over the longer term, however, this situation is definitely not stable.

Three major factors underlie today’s low yields. First and foremost, there is the “global savings glut,” an idea popularized by current Federal Reserve Chairman Ben Bernanke in a 2005 speech. For various reasons, savers have become ascendant across many regions. In Germany and Japan, aging populations need to save for retirement. In China, the government holds safe bonds as a hedge against a future banking crisis and, of course, as a byproduct of efforts to stabilize the exchange rate.

Similar motives dictate reserve accumulation in other emerging markets. Finally, oil exporters such as Saudi Arabia and the United Arab Emirates seek to set aside wealth during the boom years.

Second, in their efforts to combat the financial crisis, the major central banks have all brought down very short-term policy interest rates to close to zero, with no clear exit in sight. In normal times, any effort by a central bank to take short-term interest rates too low for too long will boomerang. Short-term market interest rates will fall, but, as investors begin to recognize the ultimate inflationary consequences of very loose monetary policy, longer-term interest rates will rise.

This has not yet happened, as central banks have been careful to repeat their mantra of low long-term inflation. That has been sufficient to convince markets that any stimulus will be withdrawn before significant inflationary forces gather.

But a third factor has become manifest recently. Investors are increasingly wary of a global financial meltdown, most likely emanating from Europe, but with the US fiscal cliff, political instability in the Middle East, and a slowdown in China all coming into play. Meltdown fears, even if remote, directly raise the premium that savers are willing to pay for bonds that they perceive as the most reliable, much as the premium for gold rises. These same fears are also restraining business investment, which has remained muted, despite extremely low interest rates for many companies.

It is the combination of all three of these factors that has created a “perfect storm” for super low interest rates. But how long can the storm last? Although highly unpredictable, it is easy to imagine how the process could be reversed.

For starters, the same forces that led to an upward shift in the global savings curve will soon enough begin operating in the other direction. Japan, for example, is starting to experience a huge retirement bulge, implying a sharp reduction in savings as the elderly start to draw down lifetime reserves. Japan’s past predilection toward saving has long implied a large trade and current-account surplus, but now these surpluses are starting to swing the other way.

Germany will soon be in the same situation. Meanwhile, new energy-extraction technologies, combined with a softer trajectory for global growth, are having a marked impact on commodity prices, cutting deeply into the surpluses of commodity exporters from Argentina to Saudi Arabia.

Second, many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.

It is nonsense to argue that central banks are impotent and completely unable to raise inflation expectations, no matter how hard they try. In the extreme, governments can appoint central bank leaders who have a long-standing record of stating a tolerance for moderate inflation – an exact parallel to the idea of appointing “conservative” central bankers as a means of combating high inflation.

Third, eventually the clouds over Europe will be resolved, though I admit that this does not seem likely to happen anytime soon. Indeed, things will likely get worse before they get better, and it is not at all difficult to imagine a profound restructuring of the eurozone. Nevertheless, whichever direction the euro crisis takes, its ultimate resolution will end the extreme existential uncertainty that clouds the outlook today.

Ultra-low interest rates may persist for some time. Certainly Japan’s rates have remained stable at an extraordinarily low level for a considerable period, at times falling further even as it seemed that they could only rise. But today’s low interest-rate dynamic is not an entirely stable one. It could unwind remarkably quickly.

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    1. Commentedpeter fairley

      Really sticking his neck out on the forecast here? Low rates could happen for a long time, but could reverse rather quickly.

    2. CommentedRay DAMANI

      The Fourth, and perhaps the most important reason for low interest rates is: Because the FED says so.

      Diverting over $300 Billion a year in savings interest that should have been paid to savers who would spend it and help the economy, to bankers to surf the yield curve and repair their balance sheets, is a form of day "lite" robbery.

      The US Economy has grown with 5% interest rates before and can do so again. It is time to let the too big to fail banks fail or right size without this life support - which could last a generation, and is already doing harm to the current generations of young workers that will last a life time.

      Interest rates should be set to cover real inflation, not the phone version the Fed relies on that excludes food and energy.

      There are always complex 'angels on the head of a pin' academic arguments and theories to justify any economic theory. But it would be best to return to the real world of money and capital formation - the sooner the better, since what the Fed has been doing clearly is not creating the jobs it is "mandated" to create, because cheap money cannot do that. Only demand for goods and services can.

    3. CommentedAvraam Dectis

      If we have a global savings glut coincident with a debt overhang, as your column on Austerity and Debt stated, should we not employ tools that directly reduce debts and increase demand?

      QE is not the solution, it merely feeds more money into dormant bank accounts or lowers bond prices.

      Stimulative fiscal policy is out for the USA and Eurozone, mostly for political reasons.

      A new monetary tool is needed and I suggest CBD ( Central Bank Dividends ).

      CBD starts with the acknowledgement that the true owners of a Central Bank are the citizens and then uses that ownership to effectively pay the citizens a dividend on that asset.

      CBD can be structured many ways, but to use the current eurozone situation as an example:

      If a 10,000 euro CBD were declared,this would happen:

      1) Each country in the eurozone would have an account at the ECB created that would contain 10,000 euros times the number of citizens in that country.

      2) Those countries would be allowed to draw upon those funds only for debt repayment. In Greece's example, this would provide several years of relief from debt payments.

      3) This would be stimulative and give countries that need to restructure the time to do it.

      Concerns of monetization or inflation could be assuaged with the assurance that if inflation became a problem, further access to the funds would be denied.

      This is a direct way to attack excessive debt and low demand. It can only be employed in highly indebted, recessionary and low inflation environments. Tailored variants could be used in any economy that meets that criteria.

      Thank you.

      Avraam Jack Dectis

    4. CommentedJim Kelley

      Is it alright to be suspicious of "savings glut". It is more like vicarious spending. The Japanese housewife lets Bubba consume her money, probably within microseconds. In the old days someone built a dovecote or planted an acre of walnuts at the birth of a child: real savings, real deferred consumption. There are not many actual resources being set aside for the future. There is a savings famine, a resource famine, little prospect of growth and therefore no reason to expect an interest payment.

    5. CommentedSayan Kombarov

      Low interest rates are destructive. They erode purchasing power of money, wipe out savings as the source of investment, create boom-bust cycle and prolong zombified life of malinvested indusries stock and real estate.

      Central banks inflation and stimulus policies only postpone the necessary and inevitable corrective crash of such mal-investments, the more so, the harder will be the devastation from the bubble they inflated when it pops!

      Meddling with market price and self-regulating mechanism on the part of central banks caused the crises, distort prices and fool investors.

      Central planning create only chaos. It's not capitalistic free market system. Whole world is flying in the dark right now, not knowing true state of the economy. We must trust market to set up interest rates and regulate money supply. Otherwise productivity, efficiency and wealth creation processes are sub-optimal or even distructive for most of population, but very profitable for special interests.

    6. CommentedDavid Smith

      Once upon a time it could be reliably assumed that candidates for office would tell the electorate what it wanted to hear, but do what was necessary once in office. This is much less certain today, perhaps because internet resonance chambers and highly-paid talking heads keep enough people in a state of irrational excitement that the specter of torches and pitchforks in the night keeps sensible heads in a state of reliable intimidation. Or maybe sensible heads just learn to stay away.

    7. CommentedJan Smith

      Higher interest rates in the foreseeable future? Perhaps so. Or perhaps not:
      • As world saving outpaces world spending, households will purchase evermore insurance against future financial instability, lower growth, and mass violence. That is to say, households will save more and spend less. So far as I can tell, no one knows how to get out of this transnational loop; indeed, too many of us cannot even see it yet.
      • As the world population explosion continues to exert downward pressure on wages, income will become more concentrated in high-income households, which allocate more of their income to economic-political disaster insurance.
      • As in the past, so in the future neo-mercantilist sovereigns will behave like high-income households. Of course, some neo-liberal sovereign somewhere might eventually figure out that carrying the world economy on its back is breaking it, and it will then become neo-mercantilist, too.

        CommentedSayan Kombarov

        High interest rates are inevitable because consumption driven by low rates bids up prices, causes inflation and price rise.

        Interest must also rise because of risks involved.

        At the moment low interest rates actually do not lead to credit expansion. Banks do not lend at all, economies are highly leveraged and prices are bid up. Deflation is coming as a result of contrary to over-expansion markets movement, it low rates aimed to avert it and decrease the cost of debt servicing, cannot stop it.

        Probably the no-retrun point is already passed. Pressing on the brakes and rasing interest will send shock to stock and bond markets as the malinvestments will become manifest.

        Rates rise is a natural process of markets trying to re-establish proper composition of money devoted to savings vs. consumption that is currently distorted worldwide.

        Please see Rothbard "America's Great Depression", Tom Woods "Meltdown".

    8. CommentedProcyon Mukherjee

      The targeting of inflation rather than output by the Fed needs a careful scrutiny; it has apparently created surge in attractiveness for stocks rather than bonds and actually did not spark meaningful economic growth which comes from output increase. But there is more to it as Fed actions by use of open market operations and announcements on funds rate is a dynamic instrument that impacts the short end of the yield curve, which includes all maturities; yield on long bonds acts as a proxy for the expectation of future short rates. When short end of the yield curve has been showing signs of constantly shifting to the lower side of the yields over some stretch of time, there has never been any dearth of investors trying to buy the Treasury bonds (every time there has been almost double the buying frenzy than what was the need which essentially means investors are willing to shell out $2 for every $1 of T-bills when the rates are auctioned at 1.6% with an inflation expectation hovering around 2% for the long periods), which brings us to the central fallacy of the argument that stocks are more attractive than bonds and that is the way it has been crafted by Fed. Large investors, who want to get away from German bonds or Japanese bonds or for that matter any bond that is not denominated in dollar, are actually betting against the fall of dollar; the size of this play is far bigger than the money moving into equities in the S&P 500.

      By creating conditions that attract investors to hedge intruments that necessarily do not spark off any economic growth leaves a sobering thought that rates are orchestrated for purposes that are not meant for revival of growth. On the contrary the common man has hardly any incentive to save, which can hardly be a desirable denouement.

      Procyon Mukherjee

    9. CommentedDavid Harry

      .."central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets," etc..

      This sounds remarkably "Keynesian" for Dr. Rogoff

        CommentedAlexis Lefranc

        Ideology does matter in this case. It's not so much central banks as governments who will need to figure out ways to make higher inflation acceptable to their electorate - cf. Germany, Japan.