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The Interest-Rate Enigma

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.

Conspicuously absent from the debate, however, is the role of financial factors in explaining the trend decline in real rates. After all, interest rates are not determined by some invisible natural force; they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking into account associated risks. Observed real interest rates are measured by deducting expected inflation from these nominal rates.