Low Interest Rates And Secular Stagnation: Is Debt A Missing Link?

 

Real interest rates have fallen to historic lows, and some economists are concerned that an era of secular stagnation has begun. This column highlights the role of policy frameworks and financial factors – particularly debt – in linking low real interest rates and sluggish economic growth. Policies that do not lean against booms but ease aggressively and persistently in busts induce a downward bias in interest rates over time and an upward bias in debt levels – something akin to a debt trap. Low real interest rates may thus be self-reinforcing and not always ‘natural’.

Today, the US government can borrow for ten years at a fixed rate of around 2.5%. Adjusted for expected inflation, this translates into a real borrowing cost of under 0.5%. A year ago, real rates were actually negative. With low interest rates dominating the developed world, many worry that an era of secular stagnation has begun (Summers 2013).

The prevailing view is that the downward trend largely reflects a fall in equilibrium or ‘natural’ interest rates, driven by changes in saving and investment fundamentals (IMF 2014). In other words, a higher propensity to save in emerging economies, together with investors’ growing preference for safe assets, has increased the supply of savings worldwide, even as weak growth prospects and heightened uncertainty in advanced economies have depressed investment demand.

This perceived decline in ‘natural’ interest rates, to negative levels according to many observers, is viewed as a key obstacle to economic recovery – it prevents monetary policy from providing sufficient stimulus by pushing real rates below their equilibrium level given the zero lower bound on nominal rates. How to stem the decline in equilibrium rates has thus become the subject of lively debate.

Fumbling in the Dark

Conspicuously absent from the debate, however, is the role of monetary and financial factors in explaining the trend decline in real rates. After all, interest rates are not determined by some invisible natural force – they are set by people. Central banks pin down the short end of the yield curve, while financial-market participants price longer-dated yields based on how they expect monetary policy to respond to future inflation and growth, taking associated risks into account. Observed real interest rates are measured by subtracting expected inflation from these nominal rates.