Vítor Constâncio: The challenge of low real interest rates for monetary
policy
Lecture by Mr Vítor Constâncio, Vice-President of the European Central Bank, at the
Macroeconomics Symposium, Utrecht School of Economics, Utrecht,15 June 2016.
* * *
The charts can be found at the European Central Bank's website.
The Footnotes can be found at the end of the speech.
This is the full text of a speech delivered in abridged form at the Macroeconomics Symposium at Utrecht School of
Economics on 15 June 2016.
Ladies and gentlemen,
I warmly thank the organisers for inviting me to the Utrecht University Macroeconomics
Symposium, a prestigious event dedicated this year to the low interest rate environment. Low
interest rates are prevailing in advanced economies where a third of public debt is in negative
territory and deposit facility policy rates are negative in several of them. Over the past decades,
across major advanced economies both short- and long-term interest rates have experienced
a significant decline and are currently at historical lows (see chart below on Long-term interest
rates).
In 1980, long-term interest rates stood at 11.4% in the U.S. and 8.5% in Germany. On average,
over 2016 they have been about 1.9% and 0.3%, respectively and at about 0.3% for the euro
area as a whole. Short-term interest rates have witnessed an equally dramatic fall: in 1980 the
interest rate on three-month Treasury securities stood at 11.4% in the U.S. and 6.4% in
Germany; this year it has averaged about 0.3% in the U.S. and minus 0.5% in Germany. In the
euro area, the overnight interest rate has been minus 0.3%. A striking feature of the current
environment is the extent to which interest rates are in negative territory at different maturities
across so many advanced countries (see chart below on Sovereign debt yields). For example,
yields in Japan up to ten years are negative, and in the case of Switzerland this extends to 15
years.
Why are interest rates so low? Is monetary policy responsible?
Answering these questions is of crucial importance. Understandingly, low interest rates are
generating a degree of apprehension in some quarters about the potential negative
implications for savers and for the financial industry, due to the compression of interest income.
A superficial, impulsive answer is that rates are low because monetary policy keeps them low.
However, in reality, low rates are the result of real economy developments and global factors,
some of which are of a secular nature and others relate to the financial crisis.
The concept of a real equilibrium interest rate
To fully understand the present situation, it is useful to invoke the concept, controversial as it
may be, of an equilibrium (or neutral) real interest rate, determined by long-term real economic
factors and independent from monetary causes. It is based on the idea that there are real
economic forces that lead the economy to long-term equilibrium at full employment with stable
inflation. The role of monetary policy should therefore be to steer policy and market rates to
that equilibrium rate. The concept assumes therefore that money, as well as finance, are
neutral in the long run, and only act as devices that facilitate contemporaneous and
intertemporal transactions. Many general equilibrium models operate reflecting this vision,
which may be difficult to square with economies at present, on the back of the staggering
permanent loss of output resulting by the recent financial crisis.
The importance of the concept of a real equilibrium interest rate is that it provides a sort of
anchor to a monetary economy. In reality, the concept defines an optimum to which the
economy would move spontaneously in the long run if wrong policies would not disturb it. The
concept was introduced in 1898 by Knut Wicksell as he became aware that in a
creditdominated economy, where banks create money, the traditional quantity theory of money could
not explain inflation. He therefore introduced the theory of a natural real rate of interest, linked
to the marginal productivity of capital that, in combination with market interest rates, would
determine price dynamics. Prices would increase if market rates were below the natural rate,
and would decrease should the opposite be the case. As market rates are influenced by
monetary policy and somehow related to monetary aggregates, he presented his theory as a
reformulation of the quantity theory of money adapted to a credit/money economy. As he wrote
in his book "Interest and prices": "There is a certain rate of interest on loans which is neutral in
respect to commodity prices, and tends neither to raise or lower them. This is necessarily the
same as the rate of interest which would be determined by supply and demand if no use were
made of money and all lending were effected in the form of capital goods. It comes to much
the same thing to describe it as the current value of the natural rate of interest on capital."[1]
The connection with the productivity of capital in production in physical terms was kept in the
loanable funds theory of the interest rate when it refers the forces of "productivity and thrift".
Keynes, in his 1930 Treatise on Money, uses the concept of the natural rate but abandons it
in the "General Theory" as he introduces the concept of equilibrium at different levels of
employment rejecting the idea of real self-equilibrating forces and underlining the importance
of monetary factors (the liquidity preference theory) in determining the interest rates even in
the long term. As a result, some Keynesians and especially all post-Keynesians reject the
notion of the natural real equilibrium interest rate.[2] The link with the real productivity of capital
also contributed to that rejection after the famous controversy between the two Cambridge
Universities (U.K. and U.S.) in the 1960s and 70s about the possibility of aggregating different
capital goods in a capital variable with prices that need an interest rate to be calculated, when,
at the same time, the interest rate was supposed to depend on the real productivity of capital.[3]
The idea of the real equilibrium or natural rate disappeared from monetary theory and policy
during the time of the controversy between monetarists and Keynesians as also Milton
Friedman did not believe in the concept. In his 1968 paper Friedman wrote: "What if the
monetary authority chose the "natural" rate - either of interest or unemployment - as its target?
One problem is that it cannot know what the "natural" rate is. Unfortunately, we have as yet
devised no method to estimate accurately and readily the natural rate of either interest or
unemployment. And the "natural" rate will itself change from time to time. But the basic problem
is that even if the monetary authority knew the "natural" rate, and attempted to peg the market
rate at that level, it would not be led to a determinate policy. The "market" rate will vary from
the natural rate for all sorts of reasons other than monetary policy."[4] As the empirical instability
of money demand functions contributed to the demise of Friedman's monetarism based on
monetary aggregates, the concept of the real equilibrium rate in a Wicksellian sense
reemerged by the hand of Michael Woodford and Lars Svensson, when both created the theory
of inflation targeting monetary regimes. Woodford even titled his 2003 book as "Interest and
Prices" to underline the relation to Wicksell.[5] Monetary aggregates were substituted by interest
rates as the monetary instrument of choice, with monetary policy subject to a quantitative
inflation target. As the real equilibrium rate is unobservable, as in the case of Wicksell,
evidence that the policy and market rates were deviating from the natural rate would be given
by the change in inflation. The policy response was then to increase or decrease policy rates
accordingly, to address the problem. This Wicksellian approach, at the centre of the inflation
targeting theory, can also be found in optimal rules extracted from new-Keynesian macro
models as well as in the Taylor-type monetary policy rule in which the intercept is set at the
real equilibrium interest rate level.
The importance of this background is that monetary policy needs to shadow the equilibrium
rate in order to meet its stability mandate. If the real equilibrium rate is decreasing then failure
to accompany it would leave the economy with too high borrowing costs with respect to the
return on investment. This would discourage investment and consumption and generate
recessionary and deflationary pressures.
Monetary policy is therefore part of the solution and not part of the problem. By ensuring low
interest rates, monetary policy is supporting and accelerating the recovery and with this, the
return to a normalisation of inflation and subsequent normalisation of interest rates. This starts
to be visible in the U.S. where interest rates have started to increase.
To demonstrate that monetary policy did not create per se the environment of low interest rates
but is rather responding to a declining real rate of equilibrium, we need to have some empirical
idea about a concept that is unobservable. There exist, however, many different methods to
try to estimate this unobservable rate. One approach can be based on the existing medium- to
long-term market interest rates, assuming that the markets are influenced by the concept of a
long-term equilibrium real rate. Methodologies can then try to extract that wisdom of markets
by using filters or models to decompose the actual interest rates. Other methods are more
theoretical and model-based, building on the possible determinants of a real equilibrium
interest rate. I will present some estimates using both types of approaches.
Determinants behind the decline of market interest rates
A useful starting point to understand the decline in nominal risk-free long-term interest rates
over the last thirty years is to decompose their evolution into four components: expected
inflation over the lifespan of the asset, inflation and real term premia, which are the
compensation investors require for holding onto a long-term asset and finally, the expected
path of the short-term real interest rate.[6] Although data limitations make it hard to derive
empirical estimates of each element of this decomposition going far back in the past, available
estimates suggest that all components have contributed to the decline in nominal interest
rates.[7]
Taking a historical perspective, the first component, long-term inflation expectations have
declined steadily since the beginning of the 1980s to stabilise at levels around 2% in the late
1990s (see chart above on Long-term inflation expectations). The trend decline and
subsequent stabilisation are a manifestation of the success of central banks' monetary policy
in regaining control of inflation and in establishing strong credibility. In the last two years, these
benign developments have been overshadowed by the small decline in long-term inflation
expectations, with the decline in short- and medium-term inflation expectations reflecting oil
price developments and the degree of slack in the economy. From a central bank's
perspective, this was very concerning and motivated the ECB's substantial and comprehensive
policy response. I will return later to the issue to elaborate on the ECB's policy measures.
The second element of the decomposition is the nominal term premium that corresponds to
the additional return that investors demand to hold a long-term bond as opposed to rolling over
a short-term bond. It can be decomposed in the inflation premium and the real term premium.
But it is imperative to first look at the nominal term premium as a whole, as it is available over
a longer sample. Some caution is needed when interpreting the results, as premia cannot be
directly observed, and deriving estimates requires a model-based analysis.
The term premium is found to display a trend decline over the last decades (see chart below
on the Nominal term premium). This feature is robust across measures derived from alternative
models, whereas there are noticeable differences about the precise level of the premium in
specific episodes.
Breaking down the nominal term premium into its components, the real term premium and the
inflation risk premium, is subject to data limitations as estimates are based on inflation-linked
bonds or swaps which have only recently become more widespread. As a result, this prevents
a detailed assessment of the relative importance of the drivers behind the decline in the
nominal term premium from a long-term perspective. But it has to be expected that the inflation
premium has significantly declined in the 1980s and 1990s alongside the decline in inflation
expectations, with investors accepting lower compensation for bearing inflation risk.[8]
Focusing on more recent years, available estimates suggest that the inflation premium has
remained rather stable at low levels in the 2000s, and has declined in the last couple of years
probably reflecting investors' reduced concern about inflation. This may be worrisome and we
monitor these developments closely.
However, the main driving force behind the large decline in the nominal term premium
observed in 2003-2004, as well as during the global financial crisis, has been the real term
premium, as shown by Abrahams and co-authors (2015) for the U.S. and ECB staff estimates
for the euro area - available since 2005 when inflation swaps have been introduced in the euro
area (see chart below on the Decomposition of the euro area nominal term premium).[9]
One important factor exerting downward pressure on the real term premium has been the
imbalance between the reduction in the supply of and the increased demand for safe assets
at the global level, which has been exacerbated by the global financial crisis. Investors'
preference for the moneyness of safe assets - that is a preferred habitat demand for safe
assets - has in effect bid up the price of those assets and correspondingly compressed the
yield. Prior to the crisis, this was explained by the large appetite among certain emerging
economies to hold their rising savings, the so called "savings glut" (Bernanke, 2005) -
reflecting factors such as demographics and the desire to build international reserves for
precautionary reasons after the Asian crisis of the late 1990s - in U.S. safe assets. This desire
for safe assets led also to inflows into U.S. securitised assets - as well as increasing the
incentives for the financial sector to boost supply - which were perceived to be safe in the
years preceding the global financial crisis. However, by the start of the crisis these
assetbacked securities quickly lost their safe status. The subsequent emergence of the euro area
sovereign debt crisis also led to government bonds in certain jurisdictions being no longer
characterised as safe. According to Caballero and Farhi (2014), the global supply of safe
assets has fallen from about $20trn in 2007 to just over $12trn USD in 2011. Additional factors
that have boosted the demand for safe assets are the new liquidity regulation for banks and
the increased need of safe and liquid assets to be posted in collateralised transactions. Central
banks have, of course, contributed to the compression of premia via their quantitative easing
programmes, and I will come back to this.
The final component affecting the long-term nominal interest rate is the expected path of the
short-term real rate over the life of the asset. Although the real rate has declined at all horizons,
it is helpful to partition this path in terms of the front and intermediate segment, and the
longterm in order to better understand the drivers of these developments.
First, over the short and medium run, the balance between savings and investment, and
therefore the real interest rate, is also affected by many factors of more cyclical nature. Since
the global financial crisis in 2008, these factors have predominantly exerted downward
pressure on the real interest rate. In the case of the euro area, it has still not emerged from its
"balance sheet recession", where a severe debt overhang and tightening of credit standards
have required a substantial amount of deleveraging of both private and public sector balance
sheets, thus reducing investment and prolonging the downturn. Furthermore, it takes time to
reabsorb the over accumulation of capital and capacity that occurred prior to the crisis. Overall,
that growth remains weak in the years after a banking crisis is certainly not atypical and has
been well documented (Reinhart and Rogoff, 2009).
Second, in the long-term, market expectations about future monetary policy rates are being
very much influenced by the difficulty in normalising inflation and by the pessimistic views about
the long run growth prospects of the advanced economies which I will address later.[10]
Another way to operationalise the longer-term notion of the real interest rate is to take real
forward rates and remove the real forward premium. An advantage of using market-based
measures to derive an estimate of the equilibrium real rate is that they are forward-looking and
available on a daily basis (Bomfim, 2001). That being said, this measure is also subject to
significant shortcomings. First, removing premia rests on a model and results are usually very
sensitive to model specifications. Second, whereas the focus is on the expected real rate in
the distant future, this is the part of the model exercise that may be particularly uncertain.[11]
Third, market expectations cannot measure the equilibrium real rate per se, but only the market
perception of it, which can be exposed to bouts of excessive optimism or pessimism.
Estimates of the real equilibrium interest rate
Beyond what can be observed in the markets, it is thus important for monetary policy to
estimate a long-term real equilibrium rate. This real rate should reflect an economy at full
employment, with stable inflation close to the monetary authority's target. As I mentioned
before, that rate should be the one used as the intercept in a traditional Taylor rule.
One way of thinking about the equilibrium rate that has inspired some of the methods used, is
to connect it with the growth rate of potential output. Current estimates are clearly affected by
the fact that potential growth has been decelerating markedly in the advanced economies.
The determinants of the real interest rate in the long run are parsimoniously summarised by
the Solow growth model. Within this framework, the long-term real interest rate boils down to
productivity and population growth as well as savings behaviour. The intuition is that these
forces determine investment and therefore the demand for loanable funds, which have to be
matched by savings. Studies show that total factor productivity and population growth have
been slowing in the euro area as well as in other advanced economies for decades (Gordon,
2016, Goodhart, Pardeshi and Pradhan, 2015).
Growth models with a richer demographic structure, while supporting this basic insight, allow
for more elaborated predictions. In particular, according to overlapping generations (OLG)
models which allow for life-cycle effects of consumption and savings decisions, variations in
the real rate in the long run can be linked to additional fundamental forces, like an increase in
the longevity of agents. Moreover, in comparison with the Solow model, a number of additional
general equilibrium effects matter, in such settings. For example, income inequality and the
distribution of private sector debt can matter because of deviations from the assumption of a
single representative agent. Likewise, the design of pension systems and, more broadly, fiscal
developments can matter in view of non-Ricardian model features.[12] Virtually all of these
factors shaping the real rate in the long run have been steadily exerting a drag on the real rate.
This type of OLG models open a possible response to the risks of secular stagnation of growth
that has been mentioned by Ben Bernanke, Narayana Kocherlakota and many others: in such
low interest rate environment, if the private sector does not increase investment, the public
sector could do it by increasing expenditures in infrastructure. In a non-Ricardian model more
public debt issuance would also contribute to increase interest rates.[13] There are also
additional factors of a secular nature which have altered the balance between savings and
investment and as a result, weighed on the real interest rate. This relates, for example, to the
shift towards human capital-intensive industries, such as software and finance, and away from
physical capital-intensive industries, such as manufacturing (Bean, Broda, Ito and Kroszner,
2015). In addition, the fall in the relative price of capital goods is another factor limiting
investment and deteriorating the balance with savings, and thereby the real interest rate. And
since capital markets operate on a global scale, downward pressure on returns propagates
globally.
The decline in the real interest rate in the long run is also consistent with the repeated
downward revisions in the long run growth potential of the economy that we have witnessed.
Indeed, potential growth shares some of the drivers of the real interest rate in the long run,
such as productivity and population growth. For instance, in the early part of 2003, the
Consensus estimate for U.S. long run real potential output growth was 3.1%, with recent
estimates revised down to 2.2%. In the euro area, survey expectations for long-term economic
growth have moved down from 2.2% in April 2003 to 1.4% in the latest estimates (see chart
below on Growth expectations).
This decline in economic growth in advanced economies has led some scholars to bring back
the concept of secular stagnation which was first introduced by Alvin Hansen in 1938 to portray
the decline in U.S. economic growth he envisaged on account of the decline in innovation,
population growth and investment opportunities. More recently, Robert Gordon (2016) and
Larry Summers (2016) have reignited the debate on secular stagnation, with the former
emphasising the role of supply-side factors and the latter on the chronic weakness of demand.
Both frameworks are not mutually exclusive as both supply and demand factors can interact
and reinforce each other. For example, weak demand leads to unemployment and if this
becomes prolonged, workers' human capital can diminish, which in turn reduces the potential
output of the economy (Blanchard and Summers, 1986 and Blanchard, Cerrutti and Summers,
2015).
The connection between the long-term real equilibrium rate and the potential growth rate of
the economy is therefore widely used in methodologies to estimate the real equilibrium rate,
such as the one developed by Williams and Laubach (2003). This connection is even
accentuated in a normative sense as in a simple OLG growth model with growing productivity,
the so-called golden rule that ensures the dynamic efficiency of the economy, (i.e. that the
economy does not over-invest or under-invest and maximizes consumption equally across
generations), implies that the real rate of interest has to be equal to the economy's growth rate.
Let me now turn to the description of some available model-based methods to estimate the
real equilibrium rate.
One approach to conduct the estimate, placing emphasis on the medium- to long-term, is to
use a time series approach based on a Bayesian vector auto regression (BVAR) with minimal
restrictions. For instance, a 5-year ahead forecast of the short-term real interest rate could
provide a proxy for the equilibrium real rate. This is based on the assumption that at such a
horizon, the effect of most shocks should have dissipated and as a result the forecast mainly
reflects persistent developments in the real interest rate.[14]
A more elaborated approach is to use a semi-structural model, emphasising a medium-run
concept of the equilibrium rate. In this approach, initiated by Williams and Laubach (2003) that
I just mentioned, the equilibrium rate depends on the trend growth of the potential output and
on a time-varying unobserved component that represents all the other drivers of the equilibrium
rate. This latent component and the trend growth rate are unobserved in a model with an IS
and an inverted Philips curve. In this approach, a statistical technique known as Kalman
filtering is used to estimate several unobserved variables including a time-varying equilibrium
real rate. This algorithm partially adjusts the estimates of the unobserved components based
on the distance between the model's forecasts of inflation and real GDP and the actual values
of these variables until these statistically converge.[15]
Still, an alternative approach to operationalise the equilibrium real rate - taking directly into
account the mandate of central banks to stabilise inflation over a not-too-distant horizon - is
to compute the real interest rate that, if maintained for some time, would stabilise inflation. For
the euro area, this corresponds to a level below but close to 2% over the medium-term and,
for this approach, the model by Christiano, Motto, Rostagno (2014) can be used.[16]
When applying these approaches to the euro area, it emerges that, in comparison to the years
prior to the crisis, estimates of the equilibrium real rate have sharply declined during the crisis
and have kept declining or remain in deep negative territory over the recent periods (see chart
above on Estimates of the equilibrium real rate). The estimates also show the degree of model
uncertainty surrounding the measurement of the equilibrium real rate, which of course
compound to the parameter uncertainty.[17] For comparison, the observed market real rate
discussed in the previous section is depicted in the green bar. It is apparent that the sharp
decline of the equilibrium real rate and the recent negative value is not unique to the euro area,
but it is also found by in the U.S.
These measures of the equilibrium real rate contrast with the shorter-term notion of the
equilibrium real rate typically adopted in the DSGE literature, namely, the short-term real
interest rate which at each point in time would stabilise the economy to its equilibrium level in
the absence of nominal rigidities. Evidently, this approach has the advantage that it is directly
linked to the nature of frictions in the economy. However, this measure turns out to be highly
model-dependent and volatile, limiting its practical relevance for monetary policy setting
(Barsky, Justiniano and Melosi (2014).
Overall, available measures indicate that the euro area's equilibrium real rate appears to have
turned negative and is significantly lower than it was in the past, irrespective of the specific
notion and approach used to measure it, even if its precise level is uncertain.
The use that the central bank should make of the equilibrium real interest rate is straightforward
if one follows the textbook prescription: the central bank takes the equilibrium interest rate as
being driven by structural factors which are largely beyond its control, and steers the policy
rate relative to the level of the equilibrium rate. By doing this, the central bank alters the relative
attractiveness of saving versus spending, which facilitates aggregate demand to match
aggregate supply so that the output gap is closed and price stability is ensured.
In practice, however, there are many challenges, and not only limited to the conceptual and
measurement issues I have just described. One challenge is that, in reality, there is not just
one interest rate affecting saving and investment in the economy, but there is an array of
market and bank lending rates which apply to different contracts and are linked by spreads
that vary over time. This makes the use of the concept of the equilibrium rate less
straightforward. Another challenge is the presence of the zero lower bound on nominal interest
rates. In the event of being confronted by large adverse shocks, the zero lower bound can
prevent the central bank from bringing the policy rate to the sufficiently low level that it is called
for by the declining equilibrium interest rate.
But recent experience has shown that we can look at these challenges in a less negative
manner. First, the presence of an array of interest rates can actually provide a way for the
central bank to inject additional accommodation by lowering such rates even when the policy
rate is at the zero lower bound; and, second, the lower bound may not be actually at zero but
in negative territory.
Negative interest rates and central bank's asset purchases
In effect, this has been the ECB's response to being confronted with a weak economy,
malfunctioning banks' credit intermediation and severe and persistent disinflationary forces.
Since mid-2014, our monetary measures can be categorised into three elements: first, we have
reduced the policy rates and brought the deposit facility rate into negative territory - currently
it stands at minus 40 basis points; second, we have fostered an overall easing of euro area
financial conditions via central bank's asset purchases - we have progressively expanded the
scope and size of our purchases as well as the horizon, which is intended to run until the end
of March 2017, or beyond, if necessary, and in any case until there is a sustained adjustment
in the path of inflation; third, we have re-habilitated the bank lending channel via providing
targeted long-term lending to banks at favourable conditions to support lending to the real
economy. And these policy measures have been flanked by our reinforced forward guidance
which we have provided pertaining to our future policy actions so as to clarify our policy
reaction function and reduce uncertainty and volatility and thereby, strengthen the control over
the yield curve.
Moreover, these measures are designed to work in combination, positively interacting with
each other through different channels so that the overall easing effect on financing conditions
is greater than the sum of the individual effects. In doing so, the cost of capital is reduced and
this provides the incentive for firms to undertake investment in the euro area, which is a crucial
element for absorbing the considerable amount of economic slack which exists, reducing the
high level of unemployment and boosting potential output.
Let me briefly provide some salient features of each of these policy measures.
The adoption of negative policy rates has allowed money market interest rates and the longer
end of the yield curve to decline further. While this shares some of the mechanisms of a
standard reduction of policy rates when they remain in positive territory, the adoption of
negative rates provides additional accommodation by effectively relaxing the non-negative
constraint on expectations of future short-term interest rates, thus helping to reduce long-term
yields. In the absence of negative rates, when central banks bring short-term interest rates to
zero, forward-looking investors start to think that the long-term interest they can earn by
investing in a long-term security is too low to compensate for a potential backup in yields.
Therefore, they start fearing a reversal of the low interest rate policy and prefer to invest and
lend for a very short term. In sum, a zero lower bound suggests to investors that short-term
rates can only rise and cannot fall further. This scenario was described by John Hicks in his
1937 Econometrica paper: "In an extreme case, the shortest short-term rate may perhaps be
nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the
risk that the short rate may rise during the currency of the loan, and it should be observed that
the short rate can only rise, it cannot fall."[18] To this end, we have reiterated in our last
Governing Council communication on 2 June that policy rates would remain at current levels
or lower for an extended period of time.
With our asset purchase programme (APP) - launched in January 2015 and successively
recalibrated in December 2015 and March 2016 - we have been able to provide substantial
additional accommodation over and above the easing via policy rates. And the fact that the
scope of our purchase programmes has been calibrated to include a variety of
investmentgrade financial assets has meant that our purchases have allowed the compression of several
premia across a wide range of markets in which we intervene. Via port