Last month marked the tenth anniversary of the last time the European Central Bank (ECB) raised its base rate of interest. In 2011, during the economic recovery that followed Europe’s 2007-9 recession, the ECB raised interest rates just twice (from 1 to 1.5 per cent) before taking fright later that year and speedily reversing both increases. The ECB didn’t raise its base rate at all during the years of relatively strong economic growth after 2015 that preceded the pandemic. By contrast, between 2005 and 2008 there were nine interest rate rises of 0.25 per cent.
While the ECB raised rates by a total of 2.25 per cent between 2005 and 2008, the Bank of England got away with just five rises of 0.25 per cent in the same period. It hasn’t managed a single rise since June 2007. Last week Crispin Odey, a prominent hedge fund manager, said that the Bank of England would “never” put up interest rates. Do depositors in Britain and Europe really face a future of permanently low interest rates and zero-interest income?
Nominal interest rates (the rate depositors used to get paid by their banks) can be divided into a real interest rate element and an inflation element. The inexorable drop in inflation over recent decades has caused that element to shrink and has brought retail interest rates down with it. In 1980 the Irish rate of inflation was 18.1 per cent. Last year Ireland experienced negative inflation (that is, deflation) of 0.3 per cent. Yet nominal interest rates have dropped by more than the fall in inflation. Real interest rates have also fallen into negative territory, and depositors must suffer the gradual erosion of the real value of their savings.
Why have real interest rates fallen to the point that they are now negative? The answer lies in the natural rate of interest (R* or R star), which is the theoretical rate of interest that can sustain the economy at full employment while keeping inflation constant. It’s therefore the Goldilocks rate of interest for central bankers seeking to combine economic growth with price stability. But it cannot be observed directly. Rather policymakers and economic researchers use economic models to estimate it and help central bankers guide monetary policy, just as theoretical models direct government policy on Covid-19 or climate change.
In theory the neutral rate of interest should be determined by the supply of and demand for savings. The more savings that are available, relative to investment demand for those savings, the lower will be R*. The higher investment demand for savings, relative to supply, the higher will be R*. So in practice this means the natural rate should be closely linked to the trend rate of economic growth. If interest rates — and thus the cost of capital — were persistently below the rate of economic growth, then demand for credit should increase as companies seek to profit from the gap between the lower interest rate and the higher expected rate of return from investing capital.
This all means that the trend rate of economic growth acts as a good proxy for the natural interest rate, which will balance the supply and demand for credit. Before the global financial crisis, academic estimates of R* closely followed estimates of GDP growth. Since then there has been a collapse in R*. The US and most European economies suffered a balance sheet recession in 2008-09 that affected credit demand for an extended period. Ireland offers a good example. In the economic bust overextended Irish banks, property developers and homeowners faced negative equity as their property-backed asset values dropped below the value of their debts. This put them into negative equity and theoretical insolvency. That made them less responsive to conventional efforts to stimulate the economy as they were preoccupied with fixing their own balance sheets. They tended to save any economic stimulus to repair their damaged finances rather than to spend it, as governments and central banks wished. Demand for credit dropped considerably: unlike the years before 2007, even sharply reduced interest rates failed to trigger borrowing. That failure explains, in large part, why central bankers are so willing today to contemplate policy actions that would have been considered risky yesterday.
ccording to BCA Research, at least four additional shocks since 2008 magnified the impact of the global financial crisis and help to explain the disconnect between rates of economic growth and of interest over the past decade: the euro area sovereign debt crisis; premature fiscal austerity; the 2014-15 collapse in oil prices; and the Trump administration’s aggressive use of trade tariffs. All contributed to the fall in demand for credit, which caused the natural rate of interest to decline below the rate of economic growth.
Interest rates are no more than the price to borrow or lend money. That price gets set by the supply of, and demand for, money. And if the prospect of an ageing society increases the supply of savings while recent financial accidents dent investment demand for those savings, then a fall in interest rates is the logical outcome. It was the fall in R*, rather than central bank base rate decisions, which caused retail interest rates to collapse to zero. And it is that fall which is making it ever more difficult for depositors and pension funds to sustain themselves financially from their savings.
The economic damage caused by the pandemic does not suggest a higher natural rate of interest as we go forward. But the astonishing level of policy stimulus triggered by the pandemic may. It has shifted the narrative about fiscal spending from “arguably insufficient” for the years after the global financial crisis to now “risking a dramatic overheating of the economy”.
Things may change fundamentally if the resulting avalanche of stimulus can ignite a virtuous circle of additional spending and investment, which in turn unleash increased economic growth that then feeds more spending and more investment. If that virtuous scenario unfolds, we could see a rise in the underlying rate of economic growth, a rise in the natural rate of interest and a falling away of concerns about secular stagnation. That would be good news for many people. Hope that it transpires is a key reason why central bankers are likely to err on the side of maintaining high levels of economic stimulus, even in the face of rising inflation rates.
Good read. http://cormaclucey.blogspot.com/2021/08/ecb-hopes-avalanche-of-stimulus-will.html
