Low interest rates, economic growth, and central bank credibility

In many advanced economies, both real and nominal interest rates have trended downward over the past thirty years. The outbreak of the Covid-19 pandemic seems to further add to downward pressures on interest rates – at least for the current year. Against this backdrop, a debate has emerged in the past years over the factors that might have contributed to this decline. It has been argued that this development reflects a decline in the so-called natural rate of interest – an unobserved, theoretical interest rate that is supposed to equilibrate desired savings and planned investment when there is a full employment. A lack of aggregate demand due to a decline in profitable investment opportunities and high global savings rates may have caused the natural interest rate to fall. Personally, I have always found this hypothesis convincing. Nevertheless, one might ask whether some economists and policy-observers might have relied too much on the argument that secular real forces have driven the real interest rate down. Natural rates are an analytical concept and not observable. Although one may try to estimate these natural interest rates, it always remains speculative whether they have really decreased or increased. And one may argue that the natural rates of interest  are further decreased by monetary policy measures such as quantitative easing programs. Relying too much on supposedly low natural interest rates to justify certain monetary policies could even damage the credibility and the communication of the central bank with the population.

In most advanced economies, there has been a decreasing trend in output growth rates since the 1980s. After the outbreak of the financial crisis, economic growth has been especially subdued. The decrease in economic growth rates is mirrored in the declining trend in real interest rates (real interest rates are equal to nominal interest rates minus inflation). It has been argued that this development reflects a decline in the so-called natural rate of interest – an unobserved, theoretical interest rate that is supposed to equilibrate desired savings and planned investment when there is full employment. According to this reasoning, there would be an excess of savings over investment at higher real interest rate levels. The interpretation of the low interest rate environment as reflecting a persistent excess of desired savings over investment is at the heart of the so-called “secular stagnation” view (see e.g. Summers (2013) or Summers (2015) for early discussions). According to my interpretation of the secular stagnation view, weak aggregate demand and a lack of productive investment opportunities have shifted the economy into a state of persistent stagnation at very low – if not negative – real interest rates. As a result, a vicious cycle emerges between subdued demand and low investment. Dampened aggregate demand results in low investment, which in turn reduces the economy’s potential growth.

The low interest rate environment may in turn generate asset-price bubbles; investment will temporarily increase and the economy can attain full employment, but only at the risk of financial instability threats. The secular stagnation hypothesis is of particular policy relevance because central banks have in the past adjusted their policy rates in an attempt to track the natural rate over the medium term. Provided that the natural real rate is very low or even negative and inflation rates are also low, central banks might face difficulties in setting the appropriate nominal policy rate as it might also be negative.

Because the real natural interest rate depends on desired savings and investment, it is influenced by a variety of global and domestic factors affecting savings and investment. The relatively strong co-movement in real interest rates in the past decades suggests that common factors at the global level might play a more important role than domestic factors. Slowing productivity growth is often seen as one main cause for the apparent decline in profitable investment opportunities. The fast technological progress has somewhat puzzlingly not led to higher productivity growth. Presumably, digital innovations have not yet complemented the skills of people in an optimal way.

While desired investment has probably been on a downward trend in advanced economies, desired savings (which are not necessarily equal to actual savings) may have increased (see e.g. Rachel and Smith (2015)). One can think of various reasons for that. For instance, the jobs of many people appear to be less safe, particularly because of technological developments, globalization, and against the backdrop of a real or perceived increase in the frequency of crises (think of the financial crisis and the economic crisis caused by the Covid-19 pandemic). In addition, demographic changes in many advanced and emerging economies imply that many people in working age might worry about the future and their pensions. These factors may lead to an increase in the propensity to save. In addition, one can observe for many advanced economies a rise in corporate savings through retained earnings (see e.g. Gruber and Kamin (2015)). This has led to a remarkable development since the 1990s. Some mostly big and productive firms in many advanced economies have moved from being net borrowers from the rest of the economy to being net lenders of funds.

From these perspectives, one may find that the current interest rate policies followed by the major central banks are by and large appropriate because the central bank has to follow the long-term structural economic forces driving down interest rates. However, one might also argue that the current policies of the major central banks are causing or at least reinforcing the current economic situation and even preventing a faster recovery (think of the very low or negative interest rates and the various quantitative easing programs). Central banks typically try to target inflation. However, the evolution of inflation has got more difficult to understand (it was probably always difficult). In recent decades, global factors could have become more important, which makes it more difficult for national central banks to influence inflation.

It could be that economists in the past have somewhat underestimated the effects of real (global or national) drivers on inflation (see e.g., Bordo (2017) for a good overview). Thus, inflation may not just be a monetary phenomenon. In turn, some economists may have underestimated potential effects of monetary policy on natural real interest rates. In the past years, one could hear a lot of arguments from economists, central bankers, and commentators on the falling natural real interest rate that has driven down the short-run nominal interest rates set by central banks (and the long-run interest rates in the case of some quantitative easing measures).  While there is certainly a lot of truth in these statements (I found it plausible and I still think that the exogenous fall in natural interest rates due to low productivity growth, demographic factors, or other reasons is a good way to think about current developments). Nevertheless, it seems to me that the perceived exogenous fall in the natural rate of interest could have been a too “easy” excuse – at least for some policy-makers – for maintaining the low interest rate environment. So one might question the view that central banks in the long-run more or less passively adjust central bank interest rates following the evolution of some natural rate of interest that is determined by real factors outside the reach of central banks. Natural rates are an analytical concept and not observable. Although one may try to estimate these natural interest rates, it always remains speculative whether they have really decreased or increased. Relying too much on natural interest rates to justify certain monetary policies could even damage the credibility of the central bank among the population.

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Some References

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