The persistent decline of global real interest rates since the 1980’s has been puzzling. Public debt in advanced economies is approaching record highs, yet borrowing costs have continued to decline. The good news is that a low interest rate improves fiscal sustainability for governments trying to improve their fiscal positions. The bad news is that it leaves little room for central banks to loosen monetary policy in a slowdown and encourages small and large investors to take on additional risk in their search for yield, raising potential threats to macroeconomic stability. Increased global financial integration has strengthened the commonality of interest rates across countries, and the determinants of global interest rates have shifted from savings and investment behavior in primarily advanced economies to also include that of the rising emerging market economies.
The IMF in its flagship World Economic Outlook report identifies three leading economic forces – declining investment rates in advanced economies, increased savings in emerging markets, and a portfolio shift from riskier equity to safer bonds – across both advanced and emerging markets that have been pushing the global real interest rate down. In the near term, only a modest reversal in this trend can be expected.
Aside from the sharp drop after the financial crisis, investment rates in advanced economies have been slowly declining since the 1980s. Improvements in technology and the IT revolution has led to a decline in the relative price of investment goods, reducing the demand for loans and borrowed money to finance those investments and thus placing downward pressure on interest rates. Though the volume of investment rose from 19 percent of GDP in the early 1980’s to over 22 percent in 2000, the decline in the relative price of investment goods was such that the value of investment-to-GDP was falling over that time. Since the financial crisis, excess capacity in labor markets and household deleveraging has suppressed demand, resulting in low capital spending despite huge wads of corporate cash parked in reserves or distributed back to shareholders.
On the savings side, rapid income growth in emerging market economies has helped boost savings rates from 21 percent of emerging market GDP in the mid-1980’s to 35 percent in 2013, contributing to what former Chairman Bernanke referred to as the “savings glut”. An over-supply of savings and money available to lend reduces interest rates, but according to Barry Eichengreen at UC Berkeley, there has been no major savings glut on the global scale as advanced economy savings fell. Though the rise in emerging market savings may have been faster than the drop in advanced economies, the shift in the source of global savings was a significant factor in the decline of global interest rates as emerging markets invested heavily in reserve assets and foreign exchange reserves.
Over the 1980’s and late 1990’s, real returns on bonds and equity had been declining together, until the early 2000’s when they diverged. The risk premium on equity rose after the dot-com bubble burst and bond returns fell further as emerging markets invested their large savings in U.S. Treasuries.
In addition, one significant recent factor helping keep rates low that was not elaborated on in the IMF report was the role of monetary policy after the financial crisis. Nominal rates at the zero lower bound and large amounts of liquidity provided by the Fed’s quantitative easing has certainly helped keep real rates low over the last few years, but cannot explain the declining trend since the 1980’s. Well-anchored inflation expectations after the Volcker-era and more sound monetary policy frameworks in emerging markets could have helped in keeping global rates somewhat tame.
Looking ahead, the case is weak for a strong comeback of real interest rates as many of the fundamentals driving the real rate lower over the last few years are not likely to reverse. The severe effects of the financial crisis and excess capacity in labor markets will likely keep investment rates from rising. Lower projected growth for emerging markets might reduce savings rates, but not enough to bring back interest rates to pre-2000 levels. Increasing financial regulation, increasing geopolitical risk, and the daunting challenge of financial market development in emerging markets do not support a reversal of the shift away from riskier equities. Finally, monetary policy in advanced economies may see gradual rate hikes as early as mid-2015, but only to the extent of bringing monetary policy back to a neutral, not tighter, stance.
Highly indebted advanced economies that are seeking to improve their fiscal positions have a lot to gain from persistently low real interest rates. According to the IMF, if real rates were to remain at 1.5 percent (currently at 0.4 percent), advanced economy debt as a share of GDP would decline by about 4 percentage points in five years. Also, if real rates remain below GDP growth, some debt-financed public investments may not lead to increases in public debt. As the euro crisis has shown us, however, profligate governments may exploit this advantage without thinking too many steps ahead.
On the other hand, lower and lower returns on bonds can push large investors, such as pension funds have defined-benefit obligations, to take on more risk to meet their requirements. Interest rates close to the zero bound pose a challenge for monetary policy to be effective in times of recession or stress in the banking system. These two challenges are a dangerous combination: increased exposure to risk in the financial system and ineffective monetary policy. Over the last few years, it has been monetary policy that has saved us from an even more severe and prolonged recession brought about by increased exposure to risk in the financial system. Leaving it up to policymakers on the fiscal side would not have resulted in a pretty picture. In the future, let’s hope central banks have the same firepower. After all, our faith in politicians to make big and important decisions is all but confident.