Jean-Pierre Danthine: Causes and consequences of low interest rates
Speech by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of the Swiss
National Bank, at the Swisscanto Market Outlook 2014, Lausanne, 14 November 2013.
* * *
I would like to thank Till Ebner, Fabian Gunzinger and Patrick Saner for their very valuable support in drafting this
speech.
Introduction
In the wake of the financial crisis, long-term and short-term interest rates have been at
historically low levels for several years already. This holds for advanced economies, in
general, and for Switzerland, in particular. Central banks have certainly been important
actors in this play, as the financial crisis and its economic consequences called for decisive
action: central banks around the world lowered their policy rates sharply; they then adopted
unconventional measures, often to exert direct downward pressure on long-term rates and
risk premia.
But interest rates developments are not just about monetary policy; they reflect the economic
and financial circumstances that prevail in a given situation, circumstances to which
monetary authorities have to adapt. With this in mind, I will, in the first part of my speech,
review the facts behind the currently low interest rates. In doing so, I will focus on the two
phenomena highlighted in chart 1: a secular decline in long-term interest rates since the
1980s, which had already brought interest rates to low levels before the financial crisis
began, and a cyclical component that led to the extreme lows we have seen over the last few
years. This cyclical component is the direct consequence of the financial and economic crisis
itself, the appropriate monetary policy reaction to the crisis and the increased demand for
safe assets which has fuelled capital flows into perceived safe havens such as Switzerland.
In the second part, I will describe the risks that accompany such a prolonged period of low
interest rates. In particular, I will argue that while a period of this kind does not pose a threat
to price stability in the foreseeable future, it may be a breeding ground for financial instability.
Finally, I will examine the implications of our analysis for interest rate perspectives. I will
argue that, while the current weakness of the global economy still weighs on market and
policy rates, the cyclical downturn will eventually reverse, and, over time, interest rates will
gradually recover to more normal levels.
Causes of low interest rates
But first things first. Why are interest rates so low?
When discussing the determinants of nominal long-term interest rates, it is useful to think of
them as the sum of two elements, the real long-term interest rate and the inflation premium.
Economic theory tells us that the real interest rate is the price that matches the supply of
savings with the demand for capital used for investment. Supply and demand for funds, in
turn, are determined by fundamental economic factors such as the time preference of
households to consume today relative to consuming tomorrow, as well as the productivity of
capital and demographic factors which determine future growth prospects.
To arrive at market-quoted nominal interest rates, one must add to the real rate an inflation
premium, which compensates the investor for the potential loss in the purchasing power of
money over the term of the security.
So, to shed light on the movement towards lower nominal interest rates since the 1980s, let
us examine how these two components - the real interest rate and the inflation premium -
have changed over that period.
A secular downward shift
A considerable part of the secular decline in nominal rates is the result of lower and more
stable inflation rates in advanced economies, translating into reduced inflation expectations
and a lower inflation premium (chart 2). Reduced volatility of inflation rates since the
mid1980s - a development associated with the "Great Moderation" - has probably contributed to
this.1 This reduction in the inflation premium and in volatility can, at least partly, be attributed
to the success of central banks' policies and their credible commitment to low and stable
inflation, a commitment which has become the hallmark of modern central banking.
Realised real rates - calculated as observed nominal rates minus the realised inflation rates
- have also declined, and have been substantially lower in the 2000s than in the 1980s
(chart 3). There are several potential explanations for this development.
A first explanation is the "global savings glut" hypothesis, which states that the decline in real
interest rates was the result of an increase in savings from emerging economies and
oilproducing economies. It is argued that this increase was driven by, among other things, an
accumulation of foreign exchange reserves, elevated oil prices and precautionary savings
(chart 4).2
But the decline in real rates could also result from a decrease in growth prospects - itself
caused, for instance, by a decline in the growth of productivity or population, or by
demographic shifts, particularly a reduction in the working population relative to the
nonworking population (charts 5 and 6).3
None of these possible explanations for the reduction in real interest rates has been fully
confirmed, and therefore they do not constitute a sound basis for forecasting future interest
rate developments. But the discussion highlights the fact that, in order to understand
longerterm trends in real interest rates, we have to rely on low frequency changes in fundamental
economic factors, while monetary policy does not play a primary role here.
The cyclical downturn
Let us now turn to more recent interest rate developments. As mentioned, since the financial
crisis and the global economic slump that followed, we have seen a further fall in rates to
very low levels. Three explanations are particularly relevant for this cyclical development.
First, low or negative output growth like that observed in times of recession together with the
associated pessimism about future prospects, all have a negative impact on interest rates.
Low growth and excess capacities reduce the anticipated return on capital, thus diminishing
the incentives to invest and lowering the demand for funds. At the same time, the lack of
confidence depresses demand and increases the level of savings. This combination of low
demand and a high supply of funds leads to low interest rates.
The low interest rates we currently observe are thus, first and foremost, a natural
consequence of the current state of the global economy, characterised by a substantial
slowdown of economic activity after the financial crisis and a comparatively weak recovery,
with marked underutilisation of production factors, notably labour, in many advanced
economies (chart 7).
Second, as mentioned before, the central banks of most mature economies have also
contributed to the current environment of low interest rates. They responded swiftly and
decisively to the crisis by first lowering short-term rates practically to zero, then exerting
direct pressure on longer rates. To achieve this, they engaged in "quantitative easing" and
"credit easing" policies by expanding and changing the composition of their balance sheets.
The goal of these measures was to mitigate the effects of the economic slump and stabilise
financial markets in the face of high uncertainty (charts 8 and 9).
One may wonder - and many people do - whether these policies have gone too far. While
the jury is still out on unconventional measures,4 there is no doubt that the policy of lowering
short rates to virtually zero and keeping them there was fully justified. Had this policy been
too expansionary, it would have translated into inflationary pressures. Yet, much to the
contrary, inflation in most advanced economies has been subdued and is, in some cases,
still falling even five years into the crisis. Finally, heightened uncertainty in global financial
markets has increased the demand for safe assets like government bonds. At the same time,
the supply of such safe assets has decreased as investors have increasingly questioned the
relative security of assets that were previously considered safe, a fact that is reflected in the
down-grading of several sovereign bonds. With an increased demand for and decreased
supply of safe assets, their price has been bid up and their yield pushed down.
The Swiss case
These changes in the supply and demand for safe assets are of particular relevance in the
case of Switzerland. While Switzerland has historically experienced lower interest rates than
its peers, the exceptionally low levels that have prevailed since 2009 can largely be
explained by the increased demand for risk-free investments and the perception that Swiss
franc assets constitute one of the ultimate safe havens in times of global uncertainty. The
reasons for this are well known. The country has managed to maintain a long-standing
reputation for political and economic stability. In relative terms, the Swiss economy
weathered the 2007 financial crisis rather well, being one of the first advanced countries to
reach its pre-crisis level of output. And, at less than 40%, its debt-to-GDP ratio is relatively
low.
The surge in the demand for Swiss franc assets has pushed Swiss interest rates to
unprecedented lows (chart 10). In September 2011, the three-month Libor fell to a low of
0.003% while the yield on 10-year Swiss government bonds fell to an all-time low of 0.376%
in December 2012. Temporarily, futures contracts on the three-month Libor even implied
negative future rates.
At the same time, the safe haven flows have put unprecedented upward pressure on the
Swiss franc. At its peak in early August 2011, nominal appreciation reached about 60%
against the euro and the US dollar compared to mid-2007 levels (chart 11).
In combination with weak global demand, the very substantial overvaluation of the Swiss
franc posed an acute threat of recession and carried the risk of deflationary developments.
To contain these risks, the SNB took unprecedented measures, first increasing liquidity to
historically unparalleled levels, then introducing a minimum exchange rate against the euro.
Summing up our investigation into the causes of low interest rates, the main message is that
interest rates reflect the prevailing economic and financial circumstances and the reaction of
monetary policy to these circumstances. The low levels we currently observe can be
explained by a secular downward trend that began in the 1980s, a cyclical downturn due to
the financial crisis, the correspondingly accommodative monetary policy and, in the case of
Switzerland, additional downward pressure resulting from the safe-haven demand.
But - and this brings me to my next point - such low interest rate levels are not without risk.
Consequences of a long period of low interest rates
An extended period of very accommodative monetary policy, even when fully justified as a
reaction to prevailing economic circumstances, is not without risks and side-effects. Let me
raise two issues: the risk to price stability, and the risk to financial stability.
I will start with the former. An extended period of low interest rates and abundant liquidity
inevitably generates the fear of a resurgence of the high levels of inflation that we have
witnessed in the past. Given the current situation, these fears are unwarranted.
In most advanced economies, capacities are still underutilised and output gaps are set to
close only very gradually (chart 12). Money, despite having been made available by central
banks in unprecedented amounts, has not showed up proportionally in investment and
consumption. This reality implies that inflation pressures will be contained for some time to
come.
Moreover, central banks have the necessary instruments at hand to counter inflation
pressures, if and when they manifest themselves. The implication for our analysis is that the
inflation premium in interest rates is set to remain small in the future.5
But even though the currently low policy rates are adapted to current economic realities and
do not pose a threat to price stability in the foreseeable future, they may pose a risk to
financial stability through various channels.
First, by lowering the cost of credit and increasing the value of assets, low interest rates
could provide the breeding ground for asset price and credit booms. In this regard, the
current developments in Swiss mortgage and real estate markets are telling: real estate
prices and mortgage credit have been growing with considerable momentum for several
years already. Importantly, the growth rates of both prices and credit volumes are at levels
which cannot be fully explained by fundamental factors. This has led to the built-up of
imbalances which increase the risk of a substantial price corrections and of loan losses
(charts 13 and 14).6
A second, related, danger is that low rates may induce excessive risk-taking in financial
markets - as opposed to reviving productive risk-taking, which is one of the objectives of low
policy rates. Here, the economic literature stresses two channels: investors who are unable
or unwilling to accept low returns are liable to take higher risks and increase leverage to
reach their return objective, a phenomenon known as "search for yield" (chart 15).7 In
addition, by pushing up asset prices and dampening price volatility, low interest rates reduce
measured risk and may lead investors to misjudge the true risk of a given investment.8 A long
period of low rates, for example, may lead borrowers and lenders to overestimate debt
affordability and underestimate the risk of higher debt servicing costs in the future.
Third, financial stability may be in danger when strong action by central banks during a crisis
leads market participants to rely excessively on central banks as a backstop in case of
negative shocks. This is the moral hazard problem.9
Taken together, these channels underline the risks the current "low-for-long"-situation
presents for financial stability. These risks have to be acknowledged and acted upon. The
fact that it is possible for these risks to exist while monetary policy is responding
appropriately to the macroeconomic situation perfectly illustrates the Tinbergen principle
- the number of instruments must equal the number of policy goals.10 In the current
environment, the interest rate cannot be the instrument of choice for addressing financial
stability risks.
The answer is to give more weight to what are known as macroprudential instruments
implemented as a complement to, and along-side a monetary policy that remains firmly
focused on price stability. These instruments directly target the risk-taking behaviour
underlying financial stability risks. This is exactly the approach chosen in Switzerland with the
activation of the countercyclical capital buffer. By forcing banks to build up additional capital
in the current phase of strong credit growth, the regulators aim at improving the capacity of
the banking system to bear losses in the event that the identified risks materialise, while also
limiting the further build-up of these risks.
Outlook
We are now in a position to derive the implications of our analysis for the interest rate
outlook. With respect to the secular trend toward lower interest rates, two observations are in
order. First, I do not think the current situation bears the seeds for a return to the inflation
rates of the seventies, despite the fears that are sometimes expressed. As argued, I thus do
not see the reasons for a significant increase in the inflation premium. Second, as to the
other defining element of the secular trend, lower real rates, it is harder to make definitive
statements. The ultimate drivers of this development and their respective roles have not
been unambiguously clarified. For this reason, it is not possible to argue convincingly that the
secular downward trend has run its course or that it is likely to revert. This is the main
unknown in our equation.
What is certain, however, is that the crisis-induced cyclical downturn will eventually be
reversed. At some point, economies will return to more robust growth paths. Interest rates
and monetary policy will accompany this change in circumstances. Thus, making sense of
our assessment of the likely future path of interest rates hinges on our assessment of the
economic outlook. Let me be more specific here.
For the global economy, the SNB forecasts the continuation of a gradual, albeit subpar
recovery. In the near term, indicators for the US, Europe and China suggest that global
growth should gradually gain in momentum and become more broad based (chart 16).
Nevertheless, the recovery is likely to remain subdued. Households, governments and banks
in many advanced economies are still in deleveraging mode, and this attempt to reduce the
debt overhang is likely to weigh on short-term growth prospects. Moreover, persistently high
unemployment rates and tight financial conditions continue to dampen consumption
spending and business investment in several euro area countries.
Against this background, the Swiss economy is expected to continue its expansion in the
quarters to come. Available indicators hint at a fairly robust second term in 2013. For
instance, monthly data show that exports are gaining momentum, driven by the
strengthening of foreign demand. For 2013, we expect the Swiss economy to grow between
1.5% and 2%.
Despite this moderately optimistic outlook, we must be aware that downside risks remain
substantial. Let me name three: first, structural problems in Europe persist, and could cause
new market tensions. In particular, the European banking system remains vulnerable.
Second, a negative fiscal shock in the US in early 2014, caused, for instance, by renewed
political deadlock over public budget negotiations, would probably be a drag on the global
economy. Third, adjustments of the monetary policy stance in one area (e.g. the US) may
create undesired spillovers in other regions (e.g. emerging markets or Europe). This could
lead to increased volatility in financial markets.
What does this economic outlook imply for the likely evolution of interest rates? In the
analysis of potential future paths, we have to distinguish between policy rates and market
rates. Market rates, in general, respond faster to changes in the economic situation and
outlook than policy rates.
The low inflation environment, subdued economic outlook and downside risks that prevail all
warrant the continuation of a very accommodative monetary policy with low interest rates.
Given the fragile state of the global economy, a premature increase in policy rates would
carry the risk of choking off the recovery. In Switzerland, specifically, the subdued inflation
outlook (chart 17), the highly valued currency and the fact that a recurrence of financial
market tensions cannot be excluded warrant a continuation of the minimum exchange rate
policy. In the current situation, the minimum exchange rate remains an essential instrument
for preventing an undesirable tightening in monetary conditions should the upward pressure
on the Swiss franc intensify again.
Market rates are still determined by the current cyclical weakness of the global economy.
Once the global economy gets back on a stronger and broader-based growth path and
uncertainty wanes, rates should return to more normal levels. For Switzerland, this would
mean that safe haven forces would become less relevant, removing some of the additional
negative pressures on domestic interest rates.
Conclusion
In sum, given that we expect a slow, but continued improvement of the world economy,
market rates are set to gradually recover to more normal levels over time. Such a scenario
will allow central banks to progressively scale back their crisis measures and, eventually, lift
policy rates off the zero lower bound. We are clearly not there yet, however. The global
economy is still fragile and the level of uncertainty remains elevated. Markets understandably
expect policy rates to remain low for several quarters in the future.
While at a qualitative level the outlook is thus relatively clear, the road back to normality will
probably be long and possibly bumpy. After all there is no precedent for the situation we
have experienced and for the exceptional measures taken by monetary authorities. At the
same time, as we have discussed, an extended period of low interest rates may entail
significant risks for financial stability. These require the full attention of the authorities, who
should be ready to use appropriate instruments, if needed, to keep these risks in check.
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