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The Interest-Rate Enigma

The prevailing view of today's ultra-low real interest rates in much of the world is that they largely reflects a fall in equilibrium, or “natural” rates, driven by changes in saving and investment fundamentals. But this explanation neglects the role of financial factors in pushing down real rates.

BASEL – Today, the United States government can borrow for ten years at a fixed rate of around 2.5%. Adjusted for expected inflation, this translates into a real borrowing cost of under 0.5%. A year ago, real rates were actually negative. And, with low interest rates dominating the developed world, many worry that an era of secular stagnation has begun.

How problematic low real rates are depends on the reason for their decline. The prevailing view is that the downward trend largely reflects a fall in equilibrium or “natural” interest rates, driven by changes in saving and investment fundamentals. In other words, a higher propensity to save in emerging economies, together with investors’ growing preference for safe assets, has increased the supply of saving worldwide, even as weak growth prospects and heightened uncertainty in advanced economies have depressed investment demand.

This perceived decline in “natural” interest rates is viewed as a key obstacle to economic recovery, because it impedes monetary policy’s capacity to provide sufficient stimulus by pushing real rates below the equilibrium level, owing to the zero lower bound on nominal rates. How to stem the decline in equilibrium rates has thus become the subject of lively debate.

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