no. 29 september 2015 econote · standard theories of the term structure of interest rates suggest...

No. 29 SEPTEMBER 2015

ECONOTE Societe Generale

Economic and sectoral studies department

LOW INTEREST RATES: THE ‘NEW NORMAL’? In the wake of the 2008 crisis, interest rates in all the highest-rated

countries have fallen to unprecedented low levels. And in Europe, many

yields have crossed the zero per cent boundary. This is a truly extraordinary

situation; even in the Depression of the 1930s nominal interest rates never

fell into negative territory. Many think that these circumstances owe much to

central banks, which would have artificially pushed down interest rates. But

more plausibly, interest rates are low because the economy is weak.

Economic theory suggests that there is an equilibrium (or ‘natural’)

rate of interest, which brings savings and investment into balance. Today, in

an era of debt overhang, there is a high likelihood that the equilibrium real

rate of interest has fallen to exceptionally low levels, probably well into

negative territory. And central bankers are essentially trying to ensure that

actual rates align with this theoretical rate so as to return output to potential.

The trouble, however, is that there is a floor beneath which actual

nominal interest rates cannot go. This floor is not exactly zero, as we used to

think, but just a tad below zero. And because of this floor, actual rates may

not be able to fall far enough to reach the equilibrium level, which may

explain why the recession that followed the 2008 crisis was so severe and

why the recovery that followed has been so slow.

What will happen next? While occasional spikes in yields are

inevitable given today’s ultra-low levels, a swift return of interest rates to

historical norms appears highly unlikely given the interplay between the

lower bound on policy rates and strong deleveraging pressures. The belief

that the main economies will operate below potential for quite some time will

continue to tie down interest rates for an extended period.

Marie-Hélène DUPRAT +33 (0)1 42 14 16 04 [email protected]

ECONOTE | No. 29 – SEPTEMBER 2015

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On April 8, Switzerland became the first government

ever to issue 10-year debt at a negative rate. On April

17, the benchmark German 10-year Bund fell as low as

0.05%. At some point, German Bunds up to the eight-

year maturity were trading at negative nominal yields.

Over the past year, Spain, Switzerland, Germany,

Austria, Finland and France have all sold short- to

medium-term debt at negative yields, meaning that

investors have been willing to pay interest for the

privilege of lending to seemingly safe governments.

This is a truly extraordinary situation; even in the

Depression of the 1930s nominal interest rates never

fell into negative territory. Revealingly, it is not only

bond yields in core European countries that have

reached remarkably low levels, it is also those in all the

other important high-income monetary areas (the USA,

Japan and the UK), although rates outside Japan have

never gone negative as in core Europe.

Consequently, concerns that the prices of the highest-

rated government bonds may have lost touch with

economic fundamentals have reached fever pitch, with

the euro zone being the epicenter of investor concerns.

The past few months have shown just how jittery

investors have become. In the middle of April, German

Bund yields shot up, triggering widespread turbulence

in global bond markets. The scale of the volatility was

impressive. After bottoming at -0.115% on April 28, the

yield on the 5-year German Bund temporarily climbed

up to 0.23% in mid-June, indicating a violent sell-off.

Contagion from the European bond rout rolled across

the Atlantic, as the spike in German Bund yields

reduced the relative attractiveness of US Treasury

yields. Yet, notwithstanding their recent rise, nominal

long-term yields in all the highest-rated countries are

still at ultra-low levels by historical standards. So the

biggest question on investors’ minds is what will

happen next? The answer to that question depends on

what you consider as the primary cause of today’s low-

return environment.

Some believe that the unconventional policies of

central banks are the dominant causal factor of the

current low-interest environment. It is often argued that

central banks’ zero interest rate policy and large-scale

purchases of government bonds have created a huge

bond bubble that is bound to burst when

unconventional policies end, triggering massive losses

for investors. Others contend that today’s low interest

rate levels are primarily a symptom of excess global

savings. According to this view, the long fall in interest

rates observed over the past two decades or so

primarily reflects a fall in the equilibrium or ‘natural’

interest rate, which balances savings and investment at

full employment. If correct, this would suggest that the

current low levels of interest rates (that is, the high

bond valuations) in core countries are fully warranted

by underlying economic fundamentals, which is

tantamount to saying that there is no bubble in the

highest-rated government bond market.

This report starts with a review of the key

developments having affected long-term nominal

interest rates in recent decades. Then, on the basis of

those considerations, it argues that although many

factors (beginning with investor resistance to ever

lower and negative yields) could cause occasional

spikes in government bond yields, economic

fundamentals in the main advanced countries are too

weak for yields on safe debt to return to historical

norms in the foreseeable future. Rather than being

viewed as the primary cause of the fall in interest rates,

central banks are instead seen as merely

accommodating deeper trends of real economic

factors that have caused the ‘equilibrium’ rate of

interest to fall to very low levels or even to go negative.

It is also emphasized that the effective lower bound on

policy rates that central banks are now facing (which

can be viewed as a price floor that distorts markets)

likely prevents the actual interest rates from falling far

enough to reach the equilibrium level. The absence of

the normal market-clearing mechanism may explain

why the economy can remain in disequilibrium for a

long time, with a shortage of demand for goods and


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labour. In this regard, Japan’s experience since the

1990s offers several instructive lessons.

All in all, then, while upward moves in interest rates

ultimately seem inevitable from their current ultra-low

levels, we believe that yields will remain well below

historical norms for an extended period – in fact, so

long as global savings do not exhibit a marked decline

or global investment a substantial strengthening.

THE DETERMINANTS OF NOMINAL LONG-TERM INTEREST RATES ON SAFE SECURITIES

Standard theories of the term structure of interest rates suggest that longer-term interest rates are

determined mainly by current short-term rates and by market expectations of future short-term rates, plus a

term premium.

So, nominal long-term interest rates can be broken down into two main components (neither of them being

directly observed), each one determined by its own set of factors:

Expectations of average future short-term interest rates until the bond matures, which can be further

broken down, via the Fisher equation, into:

1) Expectations of future real rates of interest.

Fisher’s real rate of interest is an inflation-adjusted nominal interest rate, which is often called the ‘real risk-

free interest rate’ since it is free of default risk1. It is typically interpreted as the Wicksellian natural rate of

interest (that is, the real rate of return on invested funds).

The real rate of interest is the price that balances the supply of savings and the demand for capital used for

investment. Supply and demand for funds, in turn, are determined by fundamental economic factors such as

the rates of time preference and the expected return on capital investments, which largely depends on the

trend growth rate of the economy.

2) Expectations of future inflation.

The nominal interest rate is arrived at by adding to the real risk-free rate of interest an inflation premium,

which is required by investors to compensate them for the potential loss in the purchasing power of money

over the life of the bond.

The term premium (also called the maturity risk premium), which is the extra return that investors

require to commit to buying long-term bonds rather than cumulative short-term bonds over the same period.

The term premium component is determined by the degree of uncertainty about future economic

developments, by the degree to which investors are risk-averse, as well as by a host of exogenous factors,

such as financial regulation, which can influence the demand or supply of long-term bonds.

In part, the term premium compensates investors for interest rate risk (that is, the risk that the value of long-

term bonds will change owing to a change in the level of interest rates).

Because of the term premium, long-term nominal rates are generally higher than short-term rates due to the

desire of investors for greater liquidity.

1 Note that market-quoted nominal interest rates also incorporate a premium related to issuer- and issue-related risks (also called the risk premium). This

premium varies with specific issuer and issue characteristics and explains why similar-maturity securities have differing nominal interest rates. This premium

includes the default-risk premium, which compensates the investor for the possibility that the issuer will not pay the contractual interest or principal as

scheduled, and the liquidity premium, which is demanded by investors when a bond cannot be easily converted into cash without a loss in value.


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A SECULAR DECLINE IN LONG-TERM NOMINAL INTEREST RATES

THE LONG FALL IN NOMINAL INTEREST RATES…

Never in recent economic history have the yields on

government bonds been so low for so long in most

advanced economies. Yields (which move inversely to

prices) on the government bonds of the important high-

income economies peaked in the early 1980s and then

went into a long decline, suggesting that there have

been structural changes in the economy at work.

Remarkably, there has been a strong correlation

between the movements of these yields across the

advanced economies, attesting to the importance of

common global developments2. Of course, the

behaviour of Japanese yields has long been a case

apart, reflecting the prolonged period of deflation

suffered by the country from 1997 to 2007.

But since 2012, it is not only the price of bonds in ‘safe’

countries that has shown exceptionally high values by

historical standards, it is also the price of just about

every asset category, from risky sovereign debts to

corporate bonds and stocks.

2According to the IMF, a common global factor accounted for 55% of the

change in world interest rates during the 1980-1995 period and almost 75%

during the 1996-2012 period. See International Monetary Fund (2014),

“Perspectives on global interest rates”, IMF World Economic Outlook,

Chapter 3, April. Also see Bernanke, B. S. (2013), “Long-term interest

rates”, Remarks by Ben S. Bernanke at the Annual

Monetary/Macroeconomics Conference: The Past and Future of Monetary

Policy, sponsored by the Federal Reserve Bank San Francisco, March 1.

Decline in inflation expectations

The long-term downtrend in nominal long-term interest

rates that we have observed is above all the product of

declining inflation rates, which have translated into

lower inflation expectations and a lower inflation

premium (although inertia in inflation expectations has

caused nominal long-term interest rates to fall less

rapidly than the rate of inflation). Moreover, the

reduced volatility of inflation rates since 1990 –

associated with lower inflation rates – has made

investors less averse to holding long-term bonds,

thereby boosting the attractiveness of longer-term

obligations. With investors demanding less

compensation for inflation risk, the term premium has

declined, putting downward pressure on long-term

interest rates.

The downward trend and stabilization of expected

inflation across the developed world over the past few

decades can in part be attributed to the increased

credibility of the main central banks’ commitment to a

low inflation regime. More recently, since the global

financial crisis, persistent large output gaps in the main

advanced countries have been a key driver of the

decline of both inflation and inflation expectations.


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Decline in expectations of future real yields

Over the past two decades or so, real interest rates

(calculated as observed nominal interest rates minus

inflation rates) have also shown a marked fall in all

major advanced economies. The fall in the real 10-year

interest rate – as an indication of expected returns over

a long period – suggests that markets have expected

rates to be lower for quite some time to come.

Several explanations have been put forward to account

for this downtrend in real rates. The first such

explanation is the so-called ‘global saving glut’

hypothesis, which holds that the world is in the grip of

a global saving glut mainly on the part of emerging

countries on the Pacific Rim (most notably China) and

oil producers in the Middle East from the late 1990s

until the late 2000s3. It is argued that during this period

the desire of central banks to accumulate foreign

exchange reserves, mostly in Asia, together with

generally elevated oil prices, led to an increase in

savings worldwide, and that these extra savings flew to

the USA and other advanced economies, pushing

down interest rates.

3 See Bernanke B., (2005), “The global saving glut and the US current

account deficit”, Remarks at the Sandridge Lecture, Virginia Association of

Economists.

But another possible explanation for the fall in real

rates is a downgrading of longer-term growth

prospects, which would reduce future real returns to

investment. In this case, investors would be willing to

accept lower interest rates on government debt as they

expect the rate of return on capital to be even lower.

Growth prospects could decline for a number of

reasons. Some emphasize declining productivity

growth (caused, for instance, by slowing technological

innovation). Others argue that ageing and declining

labour-supply growth are a major source of lower long-

term growth prospects in most advanced economies4.

While adverse demographics can, of course, diminish

longer-term growth prospects, the very gradual

changes in demographics that have been at work in

most countries cannot be easily squared with the sharp

drop in real interest rates that has played out in the

aftermath of the global financial crisis. Instead, other

factors must have been at work since the financial

crisis. Many point to the damage done by the Great

Recession to the economies’ labour force and

productivity, which would cause a slowdown in the

growth of economic potential (an effect called

4 The ageing of the population is considered by many researchers to be a

major reason behind Japan’s lost decade. See, for example, Shirakawa, M.

(2012), “Demographic changes and macroeconomic performance:

Japanese experiences”, Bank of Japan-IMES conference, mimeo.


6

hysteresis5). There is indeed plenty of evidence that

deep recessions have a lasting negative effect on

potential output6. And lower potential growth, in turn,

means a lower return on capital and thus lower desired

investment. Finally, others stress the accumulation of

too much debt in most high-income countries,

weighing considerably on longer-term growth

prospects.

While the ultimate drivers of the observed long-term

downtrend in real rates have not been unambiguously

proven, there is no doubt that changes in underlying

fundamental economic factors have played a key role

in this development.

5 Blanchard, Olivier, and Lawrence H. Summers (1986), “Hysteresis and the

European unemployment problem”, NBER Macroeconomics Annual 198.

See also Haltmaier, Jane (2012), “Do recessions affect potential output?”,

International Finance Discussion Paper 1066, Federal Reserve Board,

December.

6 Potential output is the level of output that an economy can produce at a

constant inflation rate. It depends on the capital stock, the potential labour

force (which depends on demographic factors and participation rates), the

non-accelerating inflation rate of unemployment (NAIRU), and the level of

labour efficiency.

…TO ULTRA-LOW OR NEGATIVE LEVELS IN THE

AFTERMATH OF THE GLOBAL FINANCIAL CRISIS

Investor pessimism about future prospects

While long-term rates had already declined to low

levels prior to the global financial crisis, they have since

fallen to unprecedented lows. These ultra-low yields

are the direct consequence of the financial and

economic crisis that left in its wake large excess

capacities (including labour), falling inflation and a

historically weak global recovery.

The remarkable yield compression observed since the

2008 crisis can be traced back to three main factors: (i)

a fall in central bank policy interest rates to ultra-low or

negative levels, (ii) investors’ expectation that short-

term rates will stay low for an extended period of time,

and (iii) a sharp increase in the net demand for longer-

term securities (in part due to higher institutional

demand for bonds, combined with a trend towards

lower investment-grade debt issuance), which has

caused a sizeable decline in term premiums.

Decline in term premiums

A whole set of special factors has led to a sharp

increase in the net demand for longer-term securities in

the aftermath of the global financial crisis, driving term


7

premiums down7. First, heightened uncertainty in

global financial markets triggered a flight-to-safety

reaction which has led to soaring yields in stressed

countries and strong demand for traditional safe-haven

government bonds such as US Treasuries, German

Bunds and Swiss franc assets. At the same time,

investors’ downgrading of several sovereign debts,

particularly in peripheral euro zone countries, led to a

marked decline in the overall supply of so-called ‘safe’

assets. The result is a shortage of risk-free assets,

which has meant that the prices of sovereign debt in

core countries perceived as the ultimate safe havens

have sky-rocketed, squeezing yields in these countries.

A powerful safe-haven effect, with shifts into Bunds

and other core government bonds, has been in play

ever since.

The shortage of safe assets has been compounded by

new regulations intended to foster financial stability,

which have constrained banks, pension funds and

insurance companies to hold more government debt –

whatever the price. Widespread ‘financial repression’,

then, has also driven the decline in term premiums in

core countries in recent years. Third, as central banks’

short-term policy rates were gradually lowered to their

zero lower bound, the volatility of Treasury bonds fell,

pushing down the term premiums. Fourth, the search

for yield engineered by the zero or negative interest

rate policies of central banks has led investors to step

up their demand for longer-duration bonds. Last but

not least, central banks themselves have become big

buyers of long-term bonds as part of their

7 Using econometric techniques Adrian et al. (2013) estimate that the term

premium (which is not directly observable) is currently negative. See Adrian,

Tobias, Richard K. Crump, and Emanuel Moench (2013), “Pricing the term

structure with linear regressions”, Federal Reserve Bank of New York Staff

Report 340:1-66. D’Amico et al. (2014) and Campbell et al. (2013) also find

evidence of a negative term premium. See D’Amico, Stefania, Don H. Kim,

and Min Wei (2014), “Tips from TIPS: the informational content of Treasury

Inflation-Protected Security prices”, Finance and Economics Discussion

Series (FEDS) Working Paper, 2014-24; Campbell, John Y., Adi Sunderam,

and Luis M. Viceira (2013), “Inflation bets or deflation hedges? The

changing risks of nominal bonds”, Harvard Business School Working Paper

09-088.

unconventional monetary policies, and the effect on

bond prices has been compounded by the fact that the

size of the bond market in several countries has

concomitantly been reduced by government fiscal

consolidation policies.

Monetary policy reaction to the crisis

Since 2008, central banks in main advanced

economies have been conducting a colossal

experiment in an effort to stimulate their economies

and fight against deflationary pressure. When the crisis

struck, the world’s main central banks slashed their

(short-term) policy interest rates, essentially to zero.

Once they hit the zero bound on policy rates, the main

central banks (the US Federal Reserve, followed by the

Bank of England and the Bank of Japan and, more

recently, the European Central Bank) then resorted to

increasingly unconventional monetary policy tools in

order to exert direct downward pressure on term and

risk premiums and thus on long-term rates (which

determine investment and consumption decisions in

the real economy)8.

In particular, central banks have dramatically increased

their monetary bases (the quantity of currency and

bank reserves in the economy) by engaging in large-

scale purchases of longer-term private or public bonds

– a process known as “quantitative easing” (QE). They

have also resorted extensively to communication

strategies (known as ‘forward rate guidance’). By

indicating that their policy rates would remain low for

an extended period of time, central banks have sought

to steer investor expectations of future short-term

8 Unconventional monetary policy aims to boost economic growth through

five main channels: (i) by encouraging banks to lend directly to the real

economy (households and corporate sector), (ii) by raising asset prices

(including while reducing the discount rate on cash flows from assets such

as dividends or rents), thus creating a positive wealth effect for asset

holders, (iii) by encouraging investors to move away from safe assets and

into higher-yielding, riskier asset classes such as stocks, (iv) by fostering

exchange rate depreciation, (v) by ensuring that inflation comes back to the

target.


8

interest rates and hence influence medium- to long-

term interest rates.

More recently, in continental Europe (the euro zone,

Denmark, Sweden and Switzerland) a new, more

extreme form of unconventional monetary policy has

been tested with the introduction of negative policy

interest rates and/or negative central bank deposit

rates. In 2012, the central bank of Denmark

implemented for the first time ever a modestly negative

policy rate. In June 2014, the ECB began paying -0.1%

on excess reserves deposited with it overnight by

banks9, before lowering the rate further to -0.2% in

September10. In late 2014 and early 2015, the Swiss

National Bank (SNB) and Sweden’s Riksbank followed

in the ECB’s footsteps by lowering their policy rates

into negative territory as well. Never before in world

economic history had policy rates been set at negative

levels.

Economists used to think that policy interest rates

could not fall below zero; otherwise, they believed,

cash would dominate bonds as an asset. Or to put it

another way, when interest rates are essentially zero,

economic agents become virtually indifferent between

holding money and holding bonds so that their demand

for liquidity becomes virtually endless – a situation

known as a ‘liquidity trap’11. As such, they talked about

9 The ECB operates on the basis of the corridor system, with three key

interest rates: (i) the main refinancing operations (MRO) rate that normally

provides most of the liquidity to monetary and financial institutions, (ii) the

marginal lending facility rate – incorporating a spread over the MRO rate –

at which banks within the Eurosystem can obtain overnight liquidity, (iii) the

deposit rate, which is the rate on the deposit facility where banks can place

their reserves in excess of the reserve requirement and which is fixed at a

spread below the MRO rate. The MRO rate is the rate that typically relates

to the rate on private interbank transactions on the overnight market, the

Euro Overnight Index Average (EONIA) rate.

10 The main goals of these policies have been diverse. While the ECB and

Riksbank have been aiming primarily to provide additional monetary

accommodation to boost economic activity and ensure a return of inflation

to targets, the SNB and DNB have mainly sought to deter capital inflows

and reduce the appreciation pressure on their currencies.

11 Under ‘normal’ circumstances, economic agents make a trade-off

between yield and liquidity; they hold money – on which they do not earn

interest – for its liquidity, but their holding of money is limited by the

nominal interest rates having a “zero lower bound”

(ZLB). But we now know that the lower bound to

interest rates is not exactly zero but slightly below zero,

as the ECB has made clear12. The reason the effective

lower bound to interest rates is lower than previously

thought is that holding liquidity has a cost for the

public. Holding cash is costly for people as it involves

storage, insurance, handling and transportation fees13.

As a result, they will be willing to hold the negative

yielding deposits (that is, to pay a charge to banks) to

the extent that banks will guarantee them that their

holdings of money will effectively be safe and available

for transactions. In fact, the cost of holding cash is

what defines the effective lower bound on policy

interest rates (i.e. the real constraint on the ability of

central banks to set negative interest rates).

Central banks can, in effect, safely reduce their policy

rates in the amount of the storage and insuring costs of

money holdings without triggering widespread

switching to cash in the economy. But once policy

rates fall too far into the negative zone, i.e. below the

costs of holding cash, people will start to saturate

themselves with money instead of holding the negative

yielding deposits. At this point, cash will be held by

people merely as a store of value, indistinguishable

from bonds, and the function of money as a medium of

exchange will become irrelevant. However, to the

opportunity cost of lost interest earnings. However, in a liquidity trap

situation, when short-term interest rates are zero, there is no opportunity

cost to liquidity and, consequently, people saturate themselves with cash.

Money is held solely for its store-of-value function, with the medium-of-

exchange-utility function becoming irrelevant.

12 The ECB clearly stated that it did not intend to bring its rate lower than -

0.2%, which was in fact the lower bound to interest rates. See Benoît

Cœuré (2015), “How binding is the zero lower bound?”, speech at the

“Removing the zero lower bound on interest rates” conference organised

by Imperial College Business School / Brevan Howard Centre for Financial

Analysis, CEPR and the Swiss National Bank, London, 18 May. To quote

him: “On this point we have been very clear: the current constellation of

policy rates is for us the effective lower bound. We do not intend to lower

short-term policy rates further.”

13 This is because money is bulky, at least when dealing with large

quantities (and thus, inconvenient to handle and use), subject to theft and

other mishaps such as counterfeiting.


9

extent that storage and other costs are fairly low,

central banks cannot reduce interest rates by much

below zero before the cash switch begins in the entire

economy, which means that zero remains, in practice,

an important benchmark for monetary policy.

Europe’s topsy-turvy world of negative interest rates

Negative policy rates, combined with the ECB’s

announcement of the launch of its €1.1tn QE

programme earlier this year14, have proved successful

in flattening the yield curve across the broad spectrum

of maturities. For instance, 10-year German Bund

yields fell to a record low of 0.05% on April 17. At one

point, German Bunds up to the height-year maturity

were trading at negative nominal yields. At present, a

huge amount of European bonds are trading at

negative nominal interest rates. At first glance, this

whole situation seems absurd: why would investors

want to pay governments to lend them money?

There are at least five reasons why investors would be

willing to lend money for a negative nominal return. The

first is the fear of deflation, as a negative nominal yield

can mean a positive real return if deflation becomes

entrenched. This rationale has prevailed in Japan over

the last 20 years and was playing out in the euro zone

in the last few months before the ECB unveiled its

€1.1tn QE program. At the start of 2015, fears of

deflation, in part linked to the fall in the oil price in the

latter half of 2014, were driving the fall in European

yields. A second reason could be heightened concerns

about tail risks (low-probability, high-impact events) in

the global economy – such as a Grexit, a hard

economic landing for China or a war between Israel

and Iran over nuclear proliferation. Against this

backdrop, holding negative-yielding bonds rather than

assets that are more volatile and thus riskier could

14 On March 5, ECB President Mario Draghi unveiled the €1.1 trillion QE

program; the ECB will buy €60bn of bonds a month until September 2016

or until inflation is back on a path towards the bank's target of close to but

below 2%.

make sense as it would reflect precautionary steps

taken by investors to reduce vulnerability to adverse

outcomes.

But investors are also willing to buy negative yielding

bonds if they expect the currency in which the asset is

denominated to appreciate (see the Swiss franc, for

example), as they will bet on a capital gain that could

more than offset the negative yield. Fourth, as seen

above, more demanding solvency regulations leave

many long-term investors (such as insurance

companies and pension funds) with no choice but to

stock up on government securities, regardless of the

yield. And fifth, investors expecting yields to keep

falling will be willing to buy negative-yielding bonds to

sell them back and pocket mark-to-market capital

gains in the process. With a whole range of captive or

price-insensitive buyers (first among them the central

banks) committed to continuing to buy large amounts

of government bonds in the coming months, there is a

clear case for government bonds as a speculative

investment.

Still, the violent German Bund sell-off in April-June

showed that there is a limit to how low yields can go

without triggering investor resistance. There was no

obvious single trigger to the Bund sell-off. In part, this

was connected to a shift in inflationary expectations

away from fears of outright deflation in Europe –

captured by a modest increase in inflation expectations


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since mid-April – as the boldness of the ECB’s move

has increased its deflation-fighting credibility.

Moreover, euro zone growth has surprised on the

upside, with a return to modest expansion in France

and Italy. Yet deterioration in liquidity conditions in core

European bond markets seems to have exacerbated

the market rout.

ARE INTEREST RATES TOO LOW?

LARGE OUTPUT GAPS REMAIN…

While unconventional monetary policy has been very

effective in creating large price effects in certain asset

markets, the jury is still out on its broader

macroeconomic effects. After more than six years of

increasingly unconventional policy tools, both inflation

and inflation expectations remain subdued throughout

the developed world and well below central bank

targets of 2% (or close to 2%), while economic growth

is still too weak to return to pre-crisis trends.

Despite zero or below-zero policy rates and huge

amounts of money creation, aggregate spending has

generally remained well below what the advanced

economies can produce, leaving sizeable output gaps

– that is, the difference between the actual output and

the level of output the economy would have at full

capacity – which keep pulling inflation down.

Sub-par recovery has been reflected in a generally

weak job market. Seven years after the global financial

crisis most of the advanced world remains far from full

employment and continues to exhibit much higher

unemployment rates than before the crisis. Even the

USA, which is ahead of the euro zone and Japan in the

economic recovery curve, has not been immune to

weak job data. Granted, measured unemployment in

North America has fallen substantially since the global

financial crisis, from a peak of 10% in October 2009 to

5.1% today. But this has mainly reflected a decline in

the number of people actively seeking jobs rather than

an increase in job availability. Since the recession

ended, job creation in the USA has only slightly

exceeded population growth, and the drop in

unemployment has owed almost entirely to the fact

that those not looking for work do not count as

unemployed.

Since early 2008, the USA’s labour force participation

rate – that is, the proportion of adults either working or

trying to find work – has fallen by 3.7 percentage

points.


11

… SUGGESTING THAT INTEREST RATES MAY BE

TOO HIGH RATHER THAN TOO LOW FOR THE REAL

ECONOMY

Although central banks have pushed their policy rates

as low as they can and have pressured down the

prices of bonds across the yield curve as much as

possible, that has still not been enough yet to return

the economy to its potential output and restore full

employment, which suggests that at current levels of

real interest rates there is an excess savings supply in

the economy.

Over a century ago, Wicksell drew the distinction

between the observed interest rate in the market place

(the interest rate on bonds) and the unobservable

equilibrium or ‘natural’ rate of interest which would

produce equilibrium between desired savings and

desired investment at full employment. The Wicksellian

natural rate of interest is the rate that leads to price

stability. When the natural rate is above the market rate

of interest, capital accumulation grows and so does

inflation; conversely, when the natural rate falls below

the market rate, the growth rate of capital accumulation

declines and deflation unfolds.

Economic theory suggests that the natural rate of

interest changes over time in response to shifts in

underlying trends of real economic factors. For

example, low productivity growth (say, because of

slowing technological innovation) will drive the natural

rate lower by reducing the expected return to capital

and discouraging investment. Likewise, ageing

populations will cause a fall in the natural rate if there is

a corresponding increase in desired savings across the

population, or if a decline in the working-age

population means that less investment is needed to

provide the necessary capital stock to employ the

labour force. A large deleveraging shock can also push

the natural real rate down, as shown by Eggertsson

and Krugman (2012)15.

Proponents of the so-called “secular stagnation”

hypothesis argue that for a variety of reasons, ranging

from adverse demographics to deleveraging, the

natural rate of interest in the main advanced economies

has gone negative16. An alternative perspective on the

perceived decline of the natural rate to very low levels

is the global savings glut hypothesis. Bernanke (2015)

argues that the world is still in the grip of a savings glut

but that the main contributor to the excess supply of

savings has, since the early 2010s, been the euro zone

– and primarily Germany, which is now the world’s

largest net exporter of both goods and financial capital

– rather than Asian and oil-producing economies,

whose contribution to the global pool of savings,

though still large, has trended downwards in recent

years17.

Whatever the cause – be it a shortfall of investment

intentions, as argued by the secular stagnation

hypothesis, or an excess of desired savings, as

claimed by the global savings glut hypothesis – there is

15 See Gauti B. Eggertsson and Paul Krugman (2011), “Debt, deleveraging, and the liquidity trap: A Fisher-Minsky-Koo approach”, The Quarterly Journal of Economics, Oxford University Press, vol. 127(3), pages 1469-1513.

16 See Summers, Lawrence H. (2014), « Reflections on the ‘New Secular Stagnation Hypothesis’”, In Coen Teulings and Richard Baldwin, eds., Secular Stagnation: Facts, Causes and Cures. London, UK: Centre for Economic Policy Research.

17 Bernanke, B. (2015), “Why are interest rates so low, part 3: the global savings glut”, Ben Bernanke’s blog, April 1.


12

now a widespread perception that the low appetite for

investment relative to the appetite for savings in the

main advanced economies, primarily the euro zone,

has caused the natural rate of interest to fall to very low

levels or even go negative.

Since the seminal work of Wicksell (1898), the natural

rate of interest has been one of the key benchmark

indicators for monetary policy. Of course, the natural

rate of interest rate is unobservable, which means that

determining its ‘true’ level is inherently difficult;

estimates of the natural rate of interest are both

uncertain and strongly model-dependent. But the

natural rate of interest offers a useful conceptual

framework for thinking about the right anchor for actual

interest rates. The ultra-low interest-rate policies of

central banks since the Great Recession of 2007–09

have essentially been an attempt to follow the natural

rate down. Given the severity of the Great Recession

and the slow recovery that followed, it is very likely that

interest rates have not been able to fall far enough to

reach the natural level. The reason, of course, is that

there is a floor beneath which actual nominal interest

rates cannot go.

THE ZERO (OR A TAD BELOW-ZERO) LOWER BOUND

A ‘liquidity trap’ occurs when an essentially zero

interest-rate policy fails to stimulate aggregate demand

in an economy that badly needs it. Liquidity traps arose

in the United States in the aftermath of the Great

Depression of the 1930s and in Japan after the

bursting of its huge real-estate bubble in 1991. A

liquidity trap can occur for various reasons. In

particular, a large deleveraging shock can easily push

an economy into a liquidity trap, as shown by

Eggertsson and Krugman (2011). This is because when

the economy is grappling with the need to massively

deleverage, even a zero interest rate may not be low

enough to induce economic agents to spend or borrow

more18.

18 Gauti B. Eggertsson and Paul Krugman (2011), (op. cit.).

The problem in a liquidity trap is that, although policy

rates are essentially at zero, nominal rates remain too

high, given prevailing levels of inflation expectations, to

deliver the (sizably) negative actual real interest rate

required to enable the economy to perform at potential

or at full employment. Or to put it another way, the

actual rate of interest is held above the natural rate,

which can leave an economy stuck in a low-inflation,

low-growth equilibrium trap. Economies in those

circumstances require either much higher inflation

expectations (which central banks have been trying

desperately to create since the crisis) or sizably

negative nominal interest rates, which is not possible

given the zero or a tad below-zero lower bound on

interest rates. So the main challenge for central banks

facing a liquidity trap is to generate higher inflation

expectations.

With the effective lower bound on interest rates

binding, main central banks have been led to adopt

other policy measures such as quantitative easing (QE)

– that is, pumping money directly into the economy – in

an effort to raise inflation expectations and boost

aggregate demand in the aftermath of the Great

Recession. QE was first attempted by Japan's central

bank to get prices rising again, starting in 2001 and

lasting five years, but that monetary stimulus

programmefailed to rid the country of its persistent

deflation. Both the Bank of England and the US Federal

Reserve19 embarked on QE in the aftermath of the 2008

financial crisis in an attempt to kick-start growth. The

Bank of Japan’s most recent QE programmebegan in

April 201320. And earlier this year, years after the

world’s other central banks resorted to QE, the ECB

launched its €1.1tn round of QE, set to run to at least

September 2016.

QE has caused the monetary base to expand quite

dramatically across the developed world in recent

years, but the fact is that measures of the money

supply or the money stock in these countries have

grown only moderately21. That trend is reflected by the

collapse in the money multiplier – as measured by the

ratio of the money stock to the monetary base – since

late 2008. The fall in the money multiplier has been

especially pronounced in the United States, and, quite

19 In November 2008, the Federal Reserve embarked on the largest monetary stimulus programme in world history. Through three successive rounds of QE it pumped almost $4.5tn into the US economy. QE was ended in October 2014.

20 Under the QE plan, the Bank of Japan vowed to buy ¥7tn yen (£46bn) of government bonds each month using electronically created money.

21 The money supply (or money stock) is the total amount of liquid or near-liquid assets in an economy. The narrowest definition of the money supply, called M1, includes currency and checking deposits. M2 includes M1 plus assets in money market accounts and small time deposits. Broad money, called M3, includes M2 plus longer-term time deposits and money market funds with more than 24-hour maturity assets.


13

remarkably, the money multiplier has not recovered

since the 2008 crisis, illustrating how profoundly the

historical relationship between the monetary base, the

money supply and the economy has come apart.

It has taken huge asset purchases by the Federal

Reserve to achieve only modest results: inflation in the

USA is, today, close to zero (0.21% through the 12

months ending July 2015). To date, there is little

convincing evidence either from the USA, the UK or

Japan that QE has any significant or lasting effect on

inflation. In fact, in the USA as in the UK and Japan,

there is a clear correlation between the launch of QE

programmes and the fall in the money multiplier,

suggesting that a large part of the dramatic increase in

the monetary base has simply led to increased liquidity

parked at the central banks.

What are the chances of success of the ECB’s new QE

programme? Its impact on inflation will depend on how

euro zone banks use their new holdings of central bank

reserves. If they hoard them as in the USA, the ECB will

most likely fail to deliver a lasting boost to inflation. If

they use their excess reserves for new lending, the

ECB stands a chance of being more successful than

the Fed at fueling inflation. A key difference between

the ECB and Fed programmes is that the Fed pays 25

basis points on bank reserves (including excess

reserves) while the ECB has a negative 20 basis point

rate. Time will tell whether negative rates discourage

banks to park their excess reserves at the ECB’s

deposit facility or spur them into extending loans.

FROM LIQUIDITY TRAPS TO ASSET PRICE

BUBBLES?

While QE programmes have helped stimulate economic

activity at the margin, these programmes have, so far,

fallen short of meeting central bank objectives on

achieving inflation targets and returning the economy

to a normal growth trajectory. This is mainly because

many factors (ranging from the increase in uncertainty

to powerful deleveraging forces) have combined to

encourage cash hoarding. Since the 2008 financial

crisis, the pressure on banks to deleverage has been

such that they have preferred to hold excess reserves

at central banks rather than lending them out. Likewise,

the pressure on households and businesses to

deleverage has been so strong that there has been little

or no appetite for borrowing regardless of rock-bottom

interest rates. So, instead of spending, the private

sector has largely held on to the cash, and the massive

amounts of money that have been created have not

shown up proportionally in investment and

consumption. To rephrase Keynes (1936), monetary

policy has seemed to be “pushing on a string”22.

This has led many economists [see notably BIS (2014)]

to argue that today’s zero interest rates and QE are

largely ineffective in stimulating GDP growth. Worse,

they are sowing the seeds of more troubles down the

line, by leading to distortions in production and

investment patterns, hampering the necessary private

sector deleveraging and fuelling asset price bubbles23.

Therefore, according to the BIS, central banks should

raise their policy rates - a policy measure which should

22 Keynes, John M (1936), The General Theory of Employment, Interest and Money, Macmillan.

23 See notably BIS (2014), 84th Annual Report, 2013/14, June 29; Borio, Claudio and Piti Disyatat (2011), “Global imbalances and the financial crisis: link or no link?”, BIS Working Paper, No. 346, May; Borio Claudio and Piti Disyatat (2014), “Low interest rates and secular stagnation: is debt a missing link?”, June 25.


14

go hand in hand with the implementation of structural

reforms. The problem, of course, is that a premature

increase in policy rates may carry the risk of choking

off the fragile recovery24. Given the current low inflation

environment, monetary policy appears ill-placed to

address concerns of potential excessive risk-taking in

the financial sector, which fall more within the

responsibility of macro-prudential policies.

NOMINAL INTEREST RATES TO REMAIN WELL BELOW HISTORICAL NORMS FOR AN EXTENDED PERIOD

THE DELEVERAGING CRISIS

Looking forward, the primary force influencing the

prospects for nominal growth in the main advanced

economies is set to be burdensome levels of private-

and public-sector debt. After the accumulation of vast

debts in the years leading up to the 2008 financial

crisis, much of the advanced world has been forced to

begin a broad deleveraging cycle. With balance sheet

repair having become the key priority for highly

indebted agents, entire sectors of the economy have

sought to save more and invest less, regardless of

ultra-low interest rates.

24 The BIS has long argued that monetary policy making has been dangerously asymmetric, as central bankers have failed to lean against the booms, while they have eased aggressively and persistently during busts. This, it is argued, has led to a downward bias in interest rates and an upward bias in debt levels, which makes it difficult to raise rates without damaging economic growth, creating something akin to a debt trap. See Hervé Hannoun (2014), “Central banks and the global debt overhang”, speech delivered at the 50th SEACEN Governors’ Conference, 20 November.

Some deleveraging has taken place in the private

sector since 2008, especially in the USA, but this

decline has been more than offset by a large increase

in public debt, particularly in the euro zone. Seven

years after the onset of the crisis, then, the debt

overhang in all advanced countries remains a major

headwind against economic recovery as many

businesses continue to slash their spending and sit on

cash.

Numerous studies indicate that when total

indebtedness in the economy reaches certain critical

levels there is a deleterious impact on economic

growth25. The Japanese economy has relapsed

numerous times over the past twenty years, and,

today, Japan’s current nominal GDP is virtually the

same as in 1991. Since the 2008 crisis, all the main

advanced economies have followed a trajectory of

brief, weak economic recovery, punctuated by

repeated relapses (slowing or negative GDP growth).

High leverage is the root cause for the

underperformance of advanced economies. At present,

25 See notably Reinhart, Carmen M. and Kenneth S. Rogoff (2009), “This time is different: Eight centuries of financial folly”, Princeton University Press; Reinhart, Carmen M. and Kenneth S. Rogoff (2009), “The aftermath of financial crises”, The American Economic Review, 99(2): 466-472; Mian A. and A. Sufi (2014), “House of debt: how they (and you) caused the great recession, and how we can prevent it from happening again”, University of Chicago Press.


15

the advanced world is exhibiting a modest cyclical

upturn in economic activity, but advanced economies

generally remain far from their productive potentials.

Moreover, there are reasons to worry that many

advanced countries are, in fact, caught in a vicious

circle from high debt to low growth and back to even

higher debt – as slow growth makes deleveraging more

difficult, which feeds back into continued slow

growth26. With private debt remaining high relative to its

2008 level and government debt continuing to trend

upward, the overhang of debt will continue to weigh on

economic growth across the main developed

economies for many years to come, leading to a

chronic deficiency of aggregate demand, which will

drag inflation and interest rates down.

MONETARY POLICIES SET TO REMAIN ULTRA-LOOSE

Of course, the impetus to deleverage will not last

forever, as balance-sheet problems should be self-

correcting given time. There are now signs that some

of the headwinds affecting some of the main advanced

economies, notably the US economy, have begun to

ease. Credit conditions in the USA have, for some time,

shown clear signs of improvement, while the US private

non-financial business sector has recently exhibited a

shift away from saving to borrowing.

26 See notably Buttiglione, L, P. Lane, L. Reichlin, and V. Reinhart (2014), “Deleveraging, what deleveraging?”, 16th Geneva Conference on Managing the World Economy, May 9, ICMB, CIMB and CEPR, Geneva.

Yet the prospect of a normalization in the monetary

stance in key high-income economies seems remote.

While the Federal Reserve has stopped its bond-buying

programme, it will be extra cautious about raising

policy rates given the country’s very low inflation rates.

As for the ECB and the Bank of Japan, they are bound

to maintain aggressively loose policy for quite some

time given current growth and inflation realities. So the

overall stance of global monetary policy is set to

remain ultra-loose for the foreseeable future, and

expectations of persistently low short-term policy rates

will anchor yields at longer-term maturities down for

quite some time to come.

PERSISTENTLY LOW INTEREST RATES TO BE

EXPECTED…

Overall, given powerful deleveraging forces, along with

other structural factors such as ageing populations, the

growing inequality of income within advanced

countries, institutional demand for bonds and the trend

towards lower investment-grade debt issuance, we

expect long-term government bond yields in the

highest-rated countries to remain low by historical

standards for quite a long time to come, even as the

Federal Reserve starts to raise rates. Yields may rise

for short periods of time as central banks’ extraordinary

reflationary efforts succeed in shifting inflationary

psychology higher, but powerful deflationary pressure,


16

together with diminished investor expectations of

medium-term growth prospects, will ensure that those

increases are limited or short-lived.

… PUNCTUATED BY BOUTS OF INCREASED

VOLATILITY

However, there is a definite risk of heightened volatility

in bond prices, for several reasons. First, when rates

reach such low levels bond prices become more

sensitive to changes in interest rates. Second, ultra-

easy monetary policy may induce excessive risk-taking

in financial markets. With central banks committed to

depressing yields by buying large amounts of bonds,

speculation on falling interest rates has become risk-

free, and the game for speculators has been to pre-

empt the central banks, buying the bonds first, often by

using leverage, in the knowledge that there is a

guaranteed exit at higher prices given that the whole

purpose of QE is to push up asset prices.

Third, the banking sector, which was a significant

provider of market liquidity for the bond markets prior

to the 2008 crisis, has since reduced its market-making

activities because of higher capital requirements and

controls on proprietary trading. Consequently, when

unexpected developments cause yields to move (such

as better-than-expected growth or unexpected oil price

rises), banks are less present in the market to smooth

excess price volatility27. Fourth, in recent years, the

weight of collective investment schemes such as

UCITS (known as OPCVMs) and ETF (Exchange Traded

Funds) has risen in the bond market. However, these

actors are more susceptible to a herd-like rush for the

exits (in case of withdrawal of their shareholders) than

the traditional long-term investors (i.e. the pension

funds and insurance companies) that used to dominate

the bond markets. The outcome here is an increased

risk of fire sales and bouts of higher price volatility.

27 See IMF Global Financial Stability Report, April 2015.


17

PREVIOUS ISSUES ECONOTE

N°28 Euro zone: in the ‘grip of secular stagnation’?

Marie-Hélène DUPRAT (March 2015)

N°27 Emerging oil producing countries: Which are the most vulnerable to the decline in oil prices?

Régis GALLAND (February 2015)

N°26 Germany: Not a “bazaar” but a factory!

Benoît HEITZ (January 2015)

N°25 Eurozone: is the crisis over? Marie-Hélène DUPRAT (September 2014)

N°24 Eurozone: corporate financing via market: an uneven development within the eurozone Clémentine GALLÈS, Antoine VALLAS (May 2014)

N°23 Ireland: The aid plan is ending - Now what? Benoît HEITZ (January 2014)

N°22 The euro zone: Falling into a liquidity trap? Marie-Hélène DUPRAT (November 2013)

N°21 Rising public debt in Japan: how far is too far? Audrey GASTEUIL (November 2013)

N°20 Netherlands: at the periphery of core countries Benoît HEITZ (September 2013)

N°19 US: Becoming a LNG exporter Marc-Antoine COLLARD (June 2013)

N°18 France: Why has the current account balance deteriorated for more than 20 years? Benoît HEITZ (June 2013)

N°17 US energy independence Marc-Antoine COLLARD (May 2013)

N°16 Developed countries: who holds public debt? Audrey GASTEUIL-ROUGIER (April 2013)

N°15 China: The growth debate Olivier DE BOYSSON, Sopanha SA (April 2013)

N°14 China: Housing Property Prices: failing to see the forest for the trees Sopanha SA (April 2013)

N°13 Financing governments debt: a vehicle for the (dis)integration of the Eurozone? Léa DAUPHAS, Clémentine GALLÈS (February 2013)

N°12 Germany’s export performance: comparative analysis with its European peers Marc FRISO (December 2012)

N°11 The Eurozone: a unique crisis Marie-Hélène DUPRAT (September 2012)

N°10 Housing market and macroprudential policies: is Canada a success story? Marc-Antoine COLLARD (August 2012)

N°9 UK Quantitative Easing: More inflation but not more activity? Benoît HEITZ (July 2012)


18

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