2023-08-16 20:32:24
As late as 2022, most monetary economists expected interest rates to stay low indefinitely. While many analysts still expect interest rates to return to near zero, they are likely to remain elevated for the foreseeable future, making it harder for governments to service their debts.
What a difference two years make. In 2021, when interest rates were close to zero in the US and UK and slightly negative in the Eurozone and Japan, the consensus was that they would stay low indefinitely. Surprisingly, as recently as January 2022, investors put the likelihood of rates in the US, Eurozone and UK to top 4% within five years at just 12%, 4% and 7%, respectively. After adjusting for expected inflation, real interest rates were negative and are expected to remain so.
In fact, despite aggressive monetary tightening by the US Federal Reserve and other central banks, real interest rates have remained significantly negative through the end of 2022. Additionally, long-term rates have risen more moderately than short-term rates: in October 2022, the yield curve had inverted, signaling that financial markets expected central banks to cut short-term rates in the near future. This sentiment stemmed from the widely held expectation that the US and global economies would enter a recession.
The Fed recently raised its key rate to 5.25%. In the United States and many other countries, real interest rates have also moved into positive territory. And now that the US appears to have avoided a recession following all, rates will likely stay well above zero for some time.
In 2021, some monetary economists believed that the “neutral” real interest rate had fallen below zero. This shift has been widely viewed as a long-term phenomenon, barring occasional cyclical fluctuations, such as spikes in interest rates during periods of unusually expansionary fiscal policy.
Given the Fed’s 2% inflation target, the zero real interest rate seemed to imply that the equilibrium nominal interest rate had to fall below 2%, on average. But US nominal interest rates cannot fall into negative territory, due to what is known as the zero lower bound.
In Europe and Japan, nominal interest rates fell slightly below zero, down to -0.5%. This was the effective lower limit. If the equilibrium real interest rate were negative and the effective lower bound for nominal rates was close to zero, the world economy would be in serious trouble. Under such conditions, monetary policy would often be too restrictive to achieve the economy’s equilibrium GDP growth rate. Responsibility for maintaining full employment should therefore fall to fiscal policy, which is often politically strained. This scenario is the “secular stagnation” hypothesis, popularized by former US Treasury Secretary Lawrence H. Summers in 2013.
In terms of fiscal policy, one of the upsides of chronically low real interest rates is that they make high levels of public debt more sustainable. Governments might operate with primary budget deficits (which exclude interest payments) and continue to manage their debt, as it would decline relative to GDP over time. However, with interest rates rising, US debt is once once more a problem. The debt-to-GDP ratio is expected to resume its upward trajectory from now on. It’s one of the reasons Fitch Ratings downgraded US debt from its longstanding AAA credit rating on Aug. 1. The global rise in real interest rates has also aggravated debt problems elsewhere, particularly in developing countries.
In 2021, investors and economists might be forgiven for believing that equilibrium interest rates had stabilized near zero for the foreseeable future. After all, short-term rates in the United States have been close to zero for nine of the previous 13 years, from 2009 to 2015 and once more from 2020 to 2021. Likewise, interest rates in the eurozone were equal or below 1% since 2009 and fell below zero in 2015. In Japan, interest rates have remained below 0.5% since 1996. Such prolonged periods of low interest rates had no been observed since the Great Depression.
Nominal and real interest rates for major countries had been on a downward trend since at least 1992. Moreover, comprehensive analyzes spanning seven centuries of data on real long-term interest rates have identified a gradual but persistent since the Renaissance, at regarding 1.2 percentage points per year.
Possible explanations for falling real interest rates include slowing productivity growth, changing demographics, growing global demand for safe and liquid assets, rising inequality, falling commodity prices equipment and a glut of savings from East Asia. Other factors, such as longer life spans and lower transaction costs, might help explain why real rates have been falling for centuries.
To be sure, leading economists have not ruled out the possibility of future interest rate hikes. But while they acknowledged the possibility of periodic rate spikes, many viewed such increases as unlikely in the short term and transitory in the long term. In 2018, Summers argued that the United States is “likely to have, by historical standards, very low rates for a very large chunk of time in the future, even in times of economic prosperity.” In 2020, together with Jason Furman, Summers reiterated that “real interest rates should remain negative”. As recently as June 2022, the former chief economist of the IMF, Olivier Blanchard, observed that “the long decline in safe interest rates stems from deep underlying factors that do not seem likely to reverse from so early”.
Nominal short-term interest rates are now above 5% and real interest rates are back in positive territory. While some monetary economists still expect interest rates to return to zero, they may have been overly influenced by the dramatic changes of 2008-21. After all, the prospect of equilibrium interest rates reaching zero or negative territory was almost unthinkable before the 2008 global financial crisis (at least outside of Japan).
Although I cannot predict the future, I am skeptical that interest rates will soon return to zero. If this assessment is correct, it bodes well for monetary policy, which would be less constrained than before. But high real interest rates are bad news for fiscal policymakers, who might find themselves once more constrained by unsustainable debt-to-GDP ratios.
Par Jeffrey Frankel
Professor of Capital Formation and Growth at Harvard University
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