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
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 eightyear 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 highestrated 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 lowreturn 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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ECONOTE | No. 29 – SEPTEMBER 2015
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 riskfree 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 longterm 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.
3
ECONOTE | No. 29 – SEPTEMBER 2015
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 highincome 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.
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.
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.
2
According 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.
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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ECONOTE | No. 29 – SEPTEMBER 2015
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 longterm 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.
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ECONOTE | No. 29 – SEPTEMBER 2015
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.
…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 shortterm rates will stay low for an extended period of time,
and (iii) a sharp increase in the net demand for longerterm 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.
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.
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
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ECONOTE | No. 29 – SEPTEMBER 2015
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 largescale 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.
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ECONOTE | No. 29 – SEPTEMBER 2015
interest rates and hence influence medium- to longterm 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.
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-ofexchange-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
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
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.
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ECONOTE | No. 29 – SEPTEMBER 2015
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.
make sense as it would reflect precautionary steps
taken by investors to reduce vulnerability to adverse
outcomes.
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%.
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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ECONOTE | No. 29 – SEPTEMBER 2015
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.
10
ECONOTE | No. 29 – SEPTEMBER 2015
… 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.
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 14691513.
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
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.
11
ECONOTE | No. 29 – SEPTEMBER 2015
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 nearliquid 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.
12
ECONOTE | No. 29 – SEPTEMBER 2015
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.
13
ECONOTE | No. 29 – SEPTEMBER 2015
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.
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.
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 privateand 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.
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.
14
ECONOTE | No. 29 – SEPTEMBER 2015
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.
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.
MONETARY POLICIES SET TO REMAIN ULTRALOOSE
Of course, the impetus to deleverage will not last
forever, as balance-sheet problems should be selfcorrecting 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.
PERSISTENTLY LOW INTEREST RATES TO BE
EXPECTED…
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.
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,
15
ECONOTE | No. 29 – SEPTEMBER 2015
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, ultraeasy 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 riskfree, and the game for speculators has been to preempt 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.
16
ECONOTE | No. 29 – SEPTEMBER 2015
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)
17
ECONOTE | No. 29 – SEPTEMBER 2015
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