SPEECH
LOW FOR LONG - CAUSES AND CONSEQUENCES
19 September 2019
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Thank you for inviting med to speak here today.
(Graph 2 - Interest rate structure, Government bonds).
The term "historically low" has been used many times to describe interest rates in recent years. In
Denmark, the key monetary policy rate has been negative since 2012 except for a few months. At
the latest auction, yields on government bonds and T-bills fell into negative territory for all matur-
ities. Recently there have even been cases where new homeowners have received payments when
taking out mortgage credit loans - that is, financing costs including fees have been negative.
A robust economy and sound economic policy is part of the explanation. This has turned Denmark
into an attractive destination for international investors in periods of high market uncertainty. This
is not the whole story though. The declining trend in interest rates is a global phenomenon and
structural in nature. Interest rates in Denmark mirror interest rate developments abroad. This is a
consequence of free international capital flows and the fixed exchange rate policy.
(Graph 3 - Actual and natural real interest rates).
Nominal rates are low, partly due to the fact that inflation is low. However, real interest rates are
also low. The estimation of the natural real interest rate - called r* (r star) - is currently a hot topic.
r* is the real interest rate level that brings actual economic activity in line with potential economic
activity. r* is not directly observable and can only be estimated with some uncertainty. However, it
is relatively well established in the literature, that r* has followed a declining trend over the past
couple of decades.
Our estimate of r* in Denmark shows a decline since the mid-1990s by approximately 4 percent-
age points. This suggests that r* became negative during the financial crisis. It has remained sub-
stantially below the pre-crisis level ever since. Although estimates of r* is surrounded by a high
degree of uncertainty, it is our assessment that r* will likely remain low in the coming years and
perhaps decline even further. This assessment builds on some of the structural drivers of the de-
cline in r*.
(Graph 4 - Global savings glut)
There are several reasons for the decline and these are global in nature. One of the most im-
portant reasons is the decline in global structural growth due to only moderate productivity
growth.
Add to this the fact that we are faced with a global savings glut. A continuous decline in the real
interest rate has been necessary to make the investment opportunities at hand profitable. A large
share of savings is concentrated among the richest people in the US, China and Japan. In the last
decade, households in countries like China have increased their demand for financial assets. This
has happened as the economy has grown, the population has aged, and demand for financial self-
insurance has increased.
Moreover, demographic changes have also played an important role for American and European
households. In a world with rising life expectancy, households tend to increase demand for sav-
ings as they face prospects of a longer life.
In our recent study on r*, we showed that savings in emerging market economies - predominantly
China - and the ongoing demographic transition in the euro area have been important drivers of
the large drop in r* in Denmark. Since the demographic transition is far from over yet, there is no
reason to believe that a "normal situation" would imply a much higher level of r* in the coming
years.
(Graph 5 - Inflation rate, long time series).
The real rate of interest is low, but so is inflation. In classical economic thinking, growth in pros-
perity is linked to labour productivity, labour supply, hours worked etc., while inflation is consid-
ered to be a purely monetary phenomenon - this is also called classical dichotomy. While mone-
tary policy cannot be decoupled from labour market developments, the link to inflation has be-
come weaker. This is often referred to as a flattening of the Phillips curve. Although labour cost
pressures have strengthened and broadened amid high levels of capacity utilisation and tighten-
ing labour markets, the pass-through to inflation is taking longer than anticipated. Few had pre-
dicted that we could reach the present low levels of unemployment without seeing rising infla-
tionary pressure.
Inflation is held at bay by globalisation: a situation where the global rather than the national la-
bour supply is playing a vital role for domestic inflation. The large pool of surplus labour in devel-
oping countries is also putting downward pressure on wages and prices in advanced economies.
Free trade and open borders result in an inflow of goods produced in low income countries and
of migrants entering the labour force.
(Graph 6 - Unconventional instruments playing a larger role).
The situation with a low r* may be regarded as a new normal. The size of r* is important for the
impact of monetary policy. Despite low or even negative policy rates, monetary policy may have a
less expansionary effect than one might think. A general concern is the lack of monetary policy
leeway to deal with the next global downturn.
The possible existence of a lower bound for monetary policy rates could challenge central banks if
they want to stimulate the economy through conventional policy instruments. The question is
whether unconventional monetary policy instruments, such as asset purchases and targeted lend-
ing, will become conventional during the next downturn. On 12 September the ECB decided on a
stimulative package that points in this direction. The leading policy rate was lowered and net pur-
chases under the asset purchase program were restarted.
Unconventional monetary policy measures also impact economic developments in Denmark, giv-
en the Danish fixed exchange rate policy. Let me remind you: Denmark is in reality a euro member
state, but with costs of currency exchanges and without influence on monetary policy decisions by
the ECB. On September 12 the Danmarks Nationalbank lowered the key policy rate in line with the
ECB.
(Graph 7 - Synchronised Nordic monetary cycles).
While Danmarks Nationalbank meets its objective of ensuring stable prices in Denmark via the
fixed exchange rate policy, many other central banks use interest rates to target inflation directly.
Although the Nordic countries have implemented different monetary policy regimes, economic
implications are in reality quite similar. The reason might be that interest rates across economies
are heavily influenced by the global financial cycle
At the centre is the Federal Reserve. There is a high degree of spill-overs between financial mar-
kets in different countries. Therefore, a change in financial conditions in a large economy like the
US quickly transmits to conditions in other financially open economies. It is thus impossible for the
Nordic countries to insulate their monetary policy from the central banks in large countries, unless
capital flows are controlled. Financial interdependence reduces the ability of monetary policy to
target domestic economic conditions independently.
The high degree of synchronisation of monetary policy rates in the Nordic countries supports this
line of thinking. We occasionally face short-term costs of procyclical interest rate changes, as seen
in the wake of the financial crisis. However, these periods occur very rarely and often last for a
very short time. Several studies find that Danish monetary policy, in general, works countercycli-
cally, as the business cycle in Denmark is highly synchronised with the business cycle in the euro
area.
Most importantly, the monetary regime should be credible. In general, evidence shows that the
choice of monetary policy regime might not be that important for stabilisation of the business cy-
cle.
Monetary policy makers are not the only ones facing challenges from the low level of interest
rates. High savings rates, few profitable investment opportunities and negative interest rates are
also imposing challenging times on investors. This includes pension funds and commercial banks.
This is not least the case in Denmark where a large part of the pension system is funded. A conse-
quence in Denmark has been that pension funds have turned their attention away from bonds and
towards equities and so-called alternative investments such as infrastructure, forests, energy sup-
ply etc. It remains to be seen whether the risks associated with these investments are correctly
estimated and priced. The lack of market prices and the lack of liquidity in many of these invest-
ments clearly pose a risk which can only be expected to materialise fully during an economic
downturn.
By reducing the stock of defined benefit pension plans, pension funds have managed to transfer a
large share of the risk stemming from the low yield environment to the pensioners. In general,
pensions are a way to allocate society's aggregate income across generations - in a closed econ-
omy this would mean domestic production. Choosing a funded system relative to for example a
pay-as-you-go system is basically a question of creating the right incentives for the financing of
pensions. That is, paying pension contributions rather than taxes. Funded pensions tend to be
better at tackling demographic changes, and pay-as-you-go systems tend to be better at coping
with large transitory shocks, e.g. large changes in inflation rates. A mixed system like the Danish
one therefore seems to be a good solution to secure a decent consumption level at retirement. If
yields on the alternative investments of pension funds turn out to disappoint, an open question
remains: who will actually pick up the bill for the retirement of our young generations? It is not
certain that future pensioners will accept lower benefits, even though they currently take on more
risk when moving towards funded pensions. The government might end up as a "pension provid-
er of last resort".
Another question is whether the low yields are affecting pension contributions to the pension
funds? On the one hand, low interest rates might make it less beneficial to transfer income into
pension savings. This is referred to as the substitution effect. On the other hand, pensioners will
need to save more to receive the same amount of benefits at retirement age - the so-called in-
come effect. Empirical studies have shown that an increase in the after-tax yield on pension sav-
ings tends to incentivise people to transfer income from other savings accounts to their pensions,
while keeping the total amount of savings unchanged. This experience points to a potential de-
cline in pension contributions due to the low interest rates. However, the prospects of a long pe-
riod with very low interest rates, the so-called "new normal", create an unprecedented situation.
So pension savers may choose to increase pension contributions to compensate for the lost yield.
Time will tell.
(Graph 8 - Banks' earnings remain high).
The low level of interest rates may also challenge banks' ability to make profits. I acknowledge
that banks are in some ways challenged by the present interest rate environment. Fortunately,
Danish banks have been able to generate profits from other sources of income. While net interest
income has dwindled, banks have increased income from both fees and administration margins
on mortgages. Moreover, a favourable macroeconomic setting is underpinned by the interest rate
policies of central banks as well as asset purchase programmes. The macroeconomic setting has
contributed to a very low level of loan impairment charges in Danish banks. In fact, Danish banks
have experienced a period of record profits in recent years. However, impairment charges cannot
continue at the currently low levels. If we look ahead, earnings should be expected to decrease
again.
(Graph 9 - Recession risks).
Even though unconventional measures remain as part of the monetary policy toolbox, there is no
doubt less leeway than previously for monetary policy to support the economy in case of a down-
turn.
This is an important insight in a situation of heightened risk of a global recession. With almost 10
years of uninterrupted growth, the US economy is experiencing a record-long economic expan-
sion. History shows that such an extended period of optimism tends to cause "speed blindness",
sowing the seeds of a downturn.
It may be difficult to predict when the US economy will be hit by a downturn or recession, but his-
torically, an inverted yield curve has signalled an upcoming recession. And at the moment, we are
facing a situation where yields on 3-month US Treasuries exceed yields on 10-year government
bonds. However, the yield curve is affected by a number of factors besides expectations of a cycli-
cal turning point. These include the Federal Reserve's asset purchase programme. This may re-
duce the predictive power of an inverted yield curve.
Surveys also indicate that the perceived recession risk in financial markets has risen in the last
couple of years. The trade conflict between the US and China may be a trigger. In general, history
shows that upswings are inevitably followed by downturns in a market economy.
The Danish economy is well-positioned to withstand a possible global downturn. The upswing
over the past six years has been balanced. Low rates have not resulted in an excessive surge in
investments nor hampered household savings. On the contrary, the household consumption ratio
is relatively low, despite rising disposable incomes and high household net wealth.
Let me conclude with a few thoughts on the title of this speech: "Low for long - causes and conse-
quences". The pertinent question is "how long is long". We do not know. What we do know is that
it will be prudent for the financial sector and investors to prepare for a long period of very low
interest rates. This is - so to speak - the new normal. It creates new challenges for the financial
sector. The only thing you can do is to adapt. And the same is true for monetary policy.
Thank you for listening.
DANMARKS
NATIONALBANK
LOW FOR LONG - CAUSES AND CONSEQUENCES
​Governor Lars Rohde, CFA Society Denmark Conference, 19 September 2019
Danish government bonds:
The whole curve is in negative territory
Per cent
1.00
0.75
0.50
Ultimo 2018
0.25
0.00
-0.25
September 2019
-0.50
-0.75
-1.00
0 5 10 15 20
Duration
Decline in the natural real interest rate (r*)
Per cent
8
Real interest rate
6
4
2
0
-2
Natural real interest rate
-4
-6
Selected contributers to the global savings glut
​Private financial wealth in per cent of global GDP
Low level of inflation at present
Per cent, y-y Per cent
25 25
Long term interest rate (right hand axes)
20 20
Inflation
15 15
10 10
5 5
0 0
-5 -5
-10 -10
-15 -15
-20 -20
Unconventional monetary policy is playing a larger role
Per cent Billion euro
8 5,000
6 4,000
Danmarks Nationalbank's monetary policy rate
4 3,000
Balance sheet ECB
2 2,000
ECB's monetary policy rate
0 1,000
-2 0
Synchronised cycle in Nordic monetary policy rates
Per cent
8
7
Norway
6
Denmark
5
Sweden
4
3
Finland
2
1
0
-1
-2
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19
Note: Danmarks Nationalbank's certificate of deposit rate for Denmark (certificate of deposit rate and lending rate are identical until June 2009). Sveriges Riksbank's
repo rate for Sweden. Norges Bank's policy rate for Norway. Until 14. October 2008, ECB's main refinancing rate for Finland, and hereafter ECB's deposit rate.
Source: Thomson Reuters Datastream and Danmarks Nationalbank.
Banks' earnings remain high
Kr. billion
60
50
40
30
Yearly profit/loss before taxes
20
10
Return on certificates of deposits at Danmarks Nationalbank
0
-10
Heightened risk of a global recession
​Note: See "Heightened risk of a global recession" , Danmarks Nationalbank Analysis no.16, 2019, for details.
​Source: Nationalbanken.