Has the era of zero interest rates come to an end for good?

 

The likelihood is that borrowing costs will remain high in the foreseeable future, posing challenges for governments in managing their debt obligations.

What a difference two years can make. In 2021, when interest rates were close to zero in the US and the UK, and slightly negative in the eurozone and Japan, the prevailing consensus was that they would stay at low levels indefinitely. Remarkably, as recently as January 2022, investors assigned only a 12% probability to interest rates in the US, eurozone, and the UK rising above 4% within the next five years—4%, and 7%, respectively. Real interest rates, adjusted for expected inflation, were even negative and projected to remain so.

Despite the US Federal Reserve and other central banks' robust efforts to tighten monetary policy, real interest rates continued to be significantly negative until late 2022. Furthermore, long-term rates increased at a more measured pace than short-term rates: by October 2022, the yield curve had inverted, indicating that financial markets anticipated central banks would decrease short-term rates in the near term. This sentiment arose from the widely held expectation that both the US and global economies were on the cusp of entering a recession.

Recently, the Federal Reserve (the Fed) raised its policy rate to 5.25%. In the United States and numerous other countries, real interest rates have also shifted into positive territory. With the US seemingly having steered clear of a recession, it's likely that interest rates will remain significantly above zero for an extended period.

Back in 2021, some monetary economists speculated that the "neutral" real interest rate had dipped below zero. This shift was widely perceived as a long-term trend, with only occasional cyclical fluctuations, such as interest rate spikes during periods of exceptionally expansive fiscal policy. Given the Fed's 2% inflation target, the zero real interest rate appeared to suggest that the equilibrium nominal interest rate should average below 2%. However, US nominal interest rates cannot drop below zero due to the constraint of the so-called zero lower bound.

In Europe and Japan, nominal interest rates did indeed slide slightly below zero, reaching levels as low as -0.5%. This marked the effective lower boundary. If the equilibrium real interest rate was negative and the effective lower boundary for nominal rates hovered close to zero, the global economy would face significant challenges. In such a scenario, monetary policy would often be too restrictive to achieve the economy's equilibrium rate of GDP growth. The responsibility for maintaining full employment would consequently shift back to fiscal policy, which frequently carries political complexities. This situation aligns with the "secular stagnation" hypothesis, which was brought to prominence by former US Treasury Secretary Lawrence H. Summers in 2013.

When discussing fiscal policy, one potential positive aspect of consistently low real interest rates is their capacity to render higher levels of public debt more sustainable. Governments could potentially operate with primary budget deficits (excluding interest payments) and still effectively manage their debt, as it would gradually decrease relative to GDP over time. Nevertheless, with the recent increase in interest rates, the issue of US debt has resurfaced. The debt-to-GDP ratio is projected to resume its upward trajectory from this point onward. This factor was among those that led Fitch Ratings to downgrade US debt from its long-standing AAA credit rating on August 1. The global elevation of real interest rates has also exacerbated debt challenges in other regions, particularly in developing nations.

In 2021, investors and economists could have been pardoned for assuming that equilibrium interest rates had settled near zero for the foreseeable future. After all, short-term rates in the US had remained close to zero for a significant portion of the prior 13 years, spanning from 2009 to 2015 and again from 2020 to 2021. Similarly, interest rates in the eurozone had either hovered at or fallen below 1% since 2009, dipping below zero in 2015. Meanwhile, Japan had maintained interest rates below 0.5% since 1996. Such prolonged periods of low interest rates had not been witnessed since the Great Depression.

Nominal and real interest rates in major nations had been experiencing a downward trajectory since at least 1992. Moreover, comprehensive analyses spanning seven centuries of data on long-term real interest rates have uncovered a gradual yet consistent decline since the Renaissance, with a reduction of approximately 1.2 percentage points per century.

Potential rationales for the diminishing trend in real interest rates encompass factors like sluggish productivity growth, shifts in demographics, escalating global demand for secure and easily convertible assets, mounting inequality, reduced costs of capital goods, and an excess of savings emanating from East Asia. Additional elements, including extended lifespans and decreased transaction costs, could contribute to understanding why real rates have been dwindling over centuries.

Certainly, esteemed economists did not dismiss the potential for forthcoming increases in interest rates. Yet, while they acknowledged the potential for occasional surges in rates, many regarded such upticks as improbable in the immediate term and temporary over the long haul. In 2018, Summers asserted that the US is "likely to have, by historical standards, very low rates for a very large fraction of time going forward, even in good economic times." In 2020, in conjunction with Jason Furman, Summers reiterated the projection that "real interest rates are expected to remain negative." As recently as June 2022, former IMF Chief Economist Olivier Blanchard observed that "the protracted decline in safe interest rates is rooted in profound underlying factors that do not appear likely to reverse anytime soon."

Currently, short-term nominal interest rates have surpassed 5%, and real interest rates have once again shifted into positive values. Despite the belief of certain monetary economists that interest rates could revert back to zero, their perspectives might have been overly influenced by the significant shifts experienced between 2008 and 2021. Before the global financial crisis of 2008, the notion of equilibrium interest rates reaching zero or turning negative was scarcely conceivable, particularly outside of Japan.

While I cannot predict the future, I hold a skeptical stance towards the likelihood of interest rates returning to zero in the near future. If this assessment proves accurate, it could be seen as advantageous for monetary policy, which would encounter fewer constraints compared to earlier times. Nevertheless, elevated real interest rates pose challenges for fiscal policymakers, as they might once again face limitations stemming from unsustainable debt-to-GDP ratios.