Low interest rates, inflation, and central bank independence

In many advanced economies, both real and nominal interest rates have trended downward over the past thirty years. After the outbreak of the Covid-19 pandemic, many central banks took further actions to reduce interest rates. It has been argued that this development reflects a decline in the so-called natural rate of interest – an unobservable theoretical interest rates – that is determined by factors such as demographic developments, lack of demand, or productivity growth. Personally, I have always found these arguments convincing. Nevertheless, one might ask whether some economists and policy-observers might have relied too much on these arguments that secular real forces have driven the real interest rate down. Natural rates are an analytical concept and not observable. Certainly, one may try to estimate these natural interest rates, but it always remains speculative whether they have really decreased or increased. It is not unplausible to argue that the natural rate of interest is further decreased by monetary policy measures such as quantitative easing programs. Thus, even though I still find the natural rate hypothesis convincing, relying too much on supposedly low natural interest rates to justify certain monetary policies could 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, which is mirrored in the declining trend in both nominal and 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 determined by desired savings and investment at full employment. According to this interpretation, the low interest rate environment reflects a persistent excess of desired savings over investment, which is at the heart of the so-called “secular stagnation” view (see e.g. Summers (2013) or Summers (2015) for early discussions).

I have always found it plausible that weak aggregate demand and a lack of productive investment opportunities have shifted the economy into a state of persistently low economic growth – 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.

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 international 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 current 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.

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. Central banks might then try to use additional tools such as quantitative easing programs to make monetary policy more expansionary. 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 buy large amounts of government bonds and other securities. In this way, they increase the demand for these assets, which tends to reduce the interest rate level. An additional challenge for central banks is the evolution of inflation, which has remained low in the recent past and which does not seem to show large reactions to the expansionary monetary policies of the past years. Central banks typically try to target inflation. However, the evolution of inflation has got more difficult to understand (it was probably always difficult). In particular, global factors could have become more important in recent decades, which makes it more difficult for national central banks to influence inflation.

In addition, it could be that economists in the past have somewhat underestimated the effects of real (global or national) drivers of inflation (see e.g., Bordo (2017) for a good overview). For instance, technological change might lead to lower prices for some products, particularly goods and services from the information and communications sector. Globalization and relocation of manufacturing and services may have also played a big role in dampening wages and prices. Thus, inflation may not just be a monetary phenomenon. In turn, it is also plausible that 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).  I think that there is certainly a lot of truth in these statements. 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 and independence of the central bank among the population.

Some Further References

Bernanke, Ben S. (2015): Why are interest rates so low, part 2: Secular stagnation, March 31, 2015.

http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/31-why-interest-rates-low-secular-stagnation

Borio, Claudio (2017): Through the looking glass, OMFIF City Lecture, 22 September 2017, London.

Grigoli, F., A. Herman and K. Schmidt-Hebbel (2014): World Saving, IMF Working Papers 14/204, International Monetary Fund.

Hamilton, J., E. Harris, Hatzius, J. and K. West (2015): The Equilibrium Real Funds Rate: Past, Present and Future, NBER Working Papers 21476, National Bureau of Economic Research.
http://www.nber.org/papers/w21476.pdf

Hansen, A. (1939): Economic Progress and Declining Population Growth, American Economic Review, 29(1).

http://www.jstor.org/stable/1806983

Holston, K., T. Laubach, and J. Williams (2016). Measuring the Natural Rate of Interest: International Trends and Determinants, Working Paper Series 2016-11. Federal Reserve Bank of San Francisco.

International Monetary Fund (2015): The New Normal: A Sector-level Perspective on Productivity Trends in Advanced Economies, IMF Staff Discussion Notes No. 15/3.

Laubach, T. and J. C. Williams (2016): Measuring the Natural Rate of Interest Redux, Finance and Economics Discussion Series 2016-11, Board of Governors of the Federal Reserve System (U.S.).

Lo, S. and K. Rogoff (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

Mokyr, J., C. Vickers, and N. L. Ziebarth (2015): The History of Technological Anxiety and the Future of Economic Growth: Is This Time Different? Journal of Economic Perspectives, 29(3): 31-50.

https://www.aeaweb.org/articles.php?doi=10.1257/jep.29.3.31

Rachel, L. and T. Smith (2015): Secular drivers of the global real interest rate, Bank of England working papers 571, Bank of England.

Taylor, J. (2016): Slow Economic Growth as a Phase in a Policy Performance Cycle, Journal of Policy Modeling, Vol. 38(3): 415-620.

Teulings, C, and R. Baldwin (eds.) (2014), Secular stagnation: facts, causes and cures, CEPR, London.

http://voxeu.org/content/secular-stagnation-facts-causes-and-cures

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