The Global Low Real Interest Rate Part 1

Low real interest rates define the current global economic environment. The yield on 10-year U.S. Treasury bonds is near all-time lows. In the euro area, the United Kingdom, and Japan, similar low yields have been widely observed as well. Even in many emerging markets such as Korea and Israel, interest rates have fallen almost 400 basis points since the financial crisis. Declines in Brazil and South Africa are less apparent, with current interest rates remaining well below previous peaks. This series of research articles strives to explain two primary questions. Why are the interest rates so low? Why is this state so widespread? (1)(2)(3)(4)(5)(6)

An intuitive answer stems from the relationship between interest rate and inflation. The real interest rate equals the difference between nominal interest rates and the inflation rate. Longer-term interest rates, in particular, reflect the market participant’s expectations of future inflation. When inflation is low, policy makers have an incentive to stimulate the economy activity level by lowering the nominal interest rate, inducing a low real interest rate. Based on this rationale, one may argue that the low rates observed may be an outcome of the economic cycle, inflation tends to move in a cyclic fashion, with the up and down of an economy. But counter to this conclusion is the historically low unemployment rate and a short-term rate, which is higher currently than the financial crisis level. If the low inflation comes from a slowing down economy, the labor market should be weak, and the short-term rate is expected to be much lower. (1)

As a result, looking somewhere else for an answer is necessary. The underlying basis for all interest rates is the natural rate of interest -- the equilibrium rate in the Keynesian Model, abbreviated as r*. The Keynesian Model approaches the interest rate from an investment and saving perspective. In his 1898 treatise Interest and Prices, Knut Wicksell wrote, "There is a certain level of the average rate of interest which is such that the general level of prices has no tendency to move either upwards or downwards." Wicksell argued that, when the economy is at its full employment, which is nearly the case today, the natural rate (r*) equals the real interest rate. The coincidence of low interest rates and low inflation suggests that the natural rate of interest is credibly very low nowadays. (1)(7)(8)(9)

A recent update of the widely cited methodology of Thomas Laubach and John Williams shows that the natural rate (r*) has fallen to 50 basis points in the U.S., 150 basis points away from its pre-financial crisis level, which does agree with a high likelihood of low current r* of current time. Even though the r* is a function sensitive to a number of assumptions, this is generally accepted within the literature. In an extension of the update analysis, Laubach, Williams, and Kathryn Holston find that this decreased natural rate of interest is a widespread phenomenon across numerous foreign economies. The decline in r* was most descriptive during the financial crisis, but it has shown little propensity to recover during the long period of time after the crisis. (1)(10)(11)(12)

There are many factors that could be responsible for applying downward pressure on the natural rate. Some of which, including quantitative easing and pronounced post-crisis demand for safe assets, could fade over time. However, there are more enduring drivers to be considered.  Going back to the fundamental supply-demand relationship may give us further direction. The natural interest rate is the equilibrium at which the supply of saving meets the demand for investment in the long run, when the economy is at full employment. So, what are the ongoing factors, affecting either the supply or demand or both of the economy? (1)

The most abiding and impactful drivers of an economy are usually the most fundamental ones, which will be directly reflected in the GDP growth rate. GDP growth in the United States was projected to be 3% (inflation adjusted) in 2019 but a recent Livingston Survey (June 2019) on private-sector economists gives an average of 2.2%, measured from the 4th Quarter one year ago. Future forecast expect 2020 GDP growth rate to slow to 1.7% and may not exceed 2% in 2021. In fact, the U.S. GDP growth rate hasn’t reached 3% since 2005. It was once expected to reach 3% in 2018, but the number again was adjusted down to 2.7%. In general, the fundamentals of the U.S. economy is likely to be culpable for the low equilibrium rate. In Part 2, the research will proceed in this direction by identifying particular factors and explaining rationale. Moreover, the effect of the changes in global account balance will be explored. (13)(14)(15)

Work Cited

1. “Speech by Vice Chairman Fischer on the Low Level of Global Real Interest Rates.” Board of Governors of the Federal Reserve System, https://www.federalreserve.gov/newsevents/speech/fischer20170731a.htm

2. “U.S. Department of the Treasury.” US Department of the Treasury, 22 Oct. 2019, https://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-LongTerm-Rate-Data-Visualization.aspx.

3. “United Kingdom Government Bond 10Y.” United Kingdom Government Bond 10Y | 2019 | Data | Chart | Calendar, https://tradingeconomics.com/united-kingdom/government-bond-yield.

4. “Japan Government Bond 10Y.” Japan Government Bond 10Y | 2019 | Data | Chart | Calendar | Forecast | News, https://tradingeconomics.com/japan/government-bond-yield.

5. “South Korea Interest Rate.” South Korea Interest Rate | 2019 | Data | Chart | Calendar | Forecast | News, https://tradingeconomics.com/south-korea/interest-rate.

6. “Israel Interest Rate.” Israel Interest Rate | 2019 | Data | Chart | Calendar | Forecast | News, https://tradingeconomics.com/israel/interest-rate.

7. Laubach, Thomas, and John C. Williams. “Measuring the Natural Rate of Interest.” Review of Economics and Statistics, vol. 85, no. 4, 2003, pp. 1063–1070., doi:10.1162/003465303772815934.

8. Lewis, Kurt F., and Francisco Vazquez-Grande (2017). "Measuring the Natural Rate of Interest: Alternative Specifications (PDF)," Finance and Economics Discussion Series 2017-059. Washington: Board of Governors of the Federal Reserve System, June.

9. Chappelow, Jim. “Keynesian Economics Definition.” Investopedia, Investopedia, 23 Aug. 2019, https://www.investopedia.com/terms/k/keynesianeconomics.asp.

10. Wicksell, Knut (1936). Interest and Prices (Geldzins und Güterpreise): A Study of the Causes Regulating the Value of Money, trans. R.F. Kahn. London: Macmillan.

11. Johannsen, Benjamin K., and Elmar Mertens (2016). "The Expected Real Interest Rate in the Long Run: Time Series Evidence with the Effective Lower Bound," FEDS Notes. Washington: Board of Governors of the Federal Reserve System, February 9.

12. Holston, Kathryn, Thomas Laubach, and John C. Williams (forthcoming). "Measuring the Natural Rate of Interest: International Trends and Determinants," in Richard Clarida and Lucrezia Reichlin, organizers, NBER International Seminar on Macroeconomics 2016. Amsterdam: Journal of International Economics (Elsevier).

13. Torry, Harriet. “Economists Dont See Path to 3% Growth in 2019.” The Wall Street Journal, Dow Jones & Company, 12 Sept. 2019, https://www.wsj.com/articles/economists-dont-see-path-to-3-growth-in-2019-11568296800.

14. Livingston Survey (June 2019) https://www.philadelphiafed.org/research-and-data/real-time-center/livingston-survey

15. “Percent Change of Gross Domestic Product.” FRED, 29 Oct. 2019, https://fred.stlouisfed.org/series/CPGDPAI.