Nominal and real interest rates in the major advanced economies, short-term and long-term, have trended downwards since the early 1980s. We see this in Figures 1 and 2.
Figure 1 Short-term nominal and real interest rates in Germany and the US, 1965-2020 (%)
Source: OECD and ESRB calculations.
Note: Short-term interest rates are based on three-month money market rates. Real rates are calculated by subtracting the annual CPI inflation rate.
Figure 2 Nominal and real ten-year government bond yields in Germany and the US, 1957-2020 (%)
Source: OECD and ESRB calculations.
Note: Yields are based on ten-year constant maturity government bond yields. Real yields are calculated by subtracting the annual CPI inflation rate.
The ‘natural’ or ‘neutral’ equilibrium real interest rate R* that would support full employment at stable and low inflation is not directly observable. Many efforts to estimate it reach similar results, however, as shown for the euro area in Figure 3.
Figure 3 Estimates of euro area equilibrium real interest rate, Q1 1999 to Q4 2019 (%)
Source: Schnabel (2020).
Notes: Ranges span point estimates across models to reflect model uncertainty and no other source or R* uncertainty. The dark shaded area highlights smoother R* estimates that are statistically less affected by cyclical movements in the real rate of interest. Latest observation: Q4 2019.
With low and stable inflation, the decline in R* has forced policy rates down towards their effective lower bound. This now appears to be somewhat though not much below zero. Market rates too are very low. Whether policy rates or market rates, the low interest rate environment (LIRE) has implications for financial stability and therefore raises issues for macroprudential policy.
The European Systemic Risk Board (ESRB), which oversees macroprudential policy in the EU, has just published a second report discussing macroprudential policy issues arising from the LIRE in the EU financial system (ESRB 2021). This work began at the end of 2019 and builds on an earlier report, which the ESRB published in 2016.
The time horizon for our analysis is medium-term: five to ten years ahead. While the report acknowledges cross-country heterogeneity, its focus is mainly on the EU financial system as a whole and on interest rates in the EU.
The report begins with an analysis of how the LIRE has been driven mainly by structural factors, such as:
- demographic developments including rising life expectancy and falling population growth rates (Acemoglu and Johnson 2007, Backus et al. 2014, Aksoy et al. 2019);
- falling (relative) price of investment goods and the rising share of intangible investment (Karabarbounis and Neiman 2014, Thwaites 2015);
- slowing pace of technological innovation (Gordon 2016);
- falling marginal product of capital (related to demography and technical progress) (Cochrane 2021);
- rising wealth and income inequality (Summers 2014, Rachel and Summers 2019)
- rising savings rates in developing countries and the consequent rising demand for assets issued by advanced economies (Bernanke 2005); and
- evolution of the consumption/wealth ratio (Gourinchas et al. 2020)
This literature is related to the ‘secular stagnation’ hypothesis revived by Summers in his speech at the IMF Research Conference in 2013. In addition, regulatory changes and the more risk-averse positioning adopted by financial institutions after the global financial crisis (GFC) have further boosted the demand for safe assets, putting more downward pressure on real interest rates and on risk premia. Many of these developments (and the trend decline in R*) hold not just for the euro area, but also for the US and Japan, and to some extent interest rates are transmitted globally (the ‘global financial cycle’; see Rey 2013).
Two recent analyses support ‘low for long’. Kiley (2020) reviews the literature and adds his own econometric study, concluding: “A range of approaches to estimating the equilibrium real interest rate confirm a pronounced downward trend among advanced economies in the level of real short-term interest rates likely to prevail over the longer term.” Gourinchas et al. (2020) agree: “Our estimates indicate that short-term real risk-free rates are expected to remain low or even negative for an extended period of time.”
But what about the COVID-19 shock? The report acknowledges that contractionary monetary policies (responding to a temporary rise in inflation) and increases in term premia (due to a temporary surge of uncertainty) could increase rates. If they were to occur, we would not expect such effects to be lasting. As long as the structural factors that have exerted downward pressure on the natural rate of interest persist, the LIRE will remain in place, at least in the medium term, according to the report. In fact, the report’s detailed overview of the effects of the COVID-19 shock concludes that it may have increased the probability and persistence of a ‘low-for-long’ scenario – so ‘even lower for even longer’.
The risk analysis of the report identifies four key areas of concern in the LIRE:
- the profitability and resilience of banks, as the LIRE accentuates the negative effects of existing structural problems in the EU banking sector, including overcapacity and cost inefficiencies;
- the indebtedness and viability of borrowers, as the LIRE facilitates higher leverage and encourages search-for-yield behaviour;
- systemic liquidity risk, as the LIRE and structural changes have made the financial system more sensitive to market shocks;
- the sustainability of the business models of insurers and pension funds offering longer-term return guarantees, as they experience increasing pressures in the LIRE.
For example, the search for yield in a fragile banking sector is clear.
Figure 4 EU banks’ credit allocation and net interest income: Net interest margins and portfolio shifts, December 2014 to June 2020
Data for EU banks provide evidence of the search for yield in the LIRE of recent years. Net interest margins trended downwards. Banks responded by increasing interest-earning assets and shifting the composition of their assets towards riskier market segments – including towards commercial real estate, consumer lending and SMEs.
Further examples abound: systemic liquidity risks, the fragility of money market funds, and the destabilising role of highly levered non-bank intermediaries were all manifest in the March 2020 market disruptions. The EU 2019 pension fund stress test found that even under the baseline scenario, the Institutions for Occupational Retirement Provision (IORPs) were underfunded by €41 billion on aggregate (4% of their liabilities) when using the regulator’s common methodology. The report’s risk analysis gives details of these and many other LIRE-related risks.
Addressing such risks requires broad-ranging macroprudential policy responses beyond the scope of existing instruments, which are limited mainly to the banking sector and borrower-based measures for households, based on national legislation. The current macroprudential toolkit does not provide instruments that can be used to deal directly with risks related to structural changes in the financial system. For example, a move from traditional banking activities and related risks to non-bank financial intermediation requires the development of macroprudential policy beyond banking and of activity-based regulation. The rise of indebtedness and leverage, the risks to market liquidity, the weaknesses in the EU banking, insurance and pension fund sectors all pose risks to financial stability that the macroprudential framework should recognise.
For each of the four areas of concern, the report suggests a range of policy options to mitigate systemic risk and to improve systemic risk analysis.
Policy options for mitigating systemic risks
1) The profitability and resilience of banks:
- address overcapacity by removing potential obstacles to banking sector consolidation and restructuring;
- reconsider the framework for dealing with weak banks;
- re-evaluate incentives for banks’ digital transformation and improving cost efficiency;
- assess legal restrictions on the application of negative interest rates to deposits.
2) The indebtedness and viability of borrowers:
- develop measures to prevent and resolve high levels of corporate indebtedness;
- develop a common minimum toolkit of borrower-based measures targeted at households.
3) Systemic liquidity risk:
- move towards macroprudential liquidity requirements.
4) The sustainability of the business models of insurers and pension funds offering longer-term return guarantees:
- include macroprudential measures for the insurance sector in the Solvency II review (in line with a separate ESRB report on macroprudential policy for the insurance sector);
- establish a recovery and resolution framework for insurance companies;
- consider issues and policy proposals raised in this and the 2016 LIRE reports for pension funds in the EU’s review of the current Directive on Institutions for Occupational Retirement Provision.
Policy options for improving systemic risk analysis
1) The indebtedness and viability of borrowers:
- build an enhanced credit and debt monitoring capacity.
2) Systemic liquidity risk:
- improve liquidity reporting and a more efficient use of already available data;
- implement system-wide liquidity stress tests.
3) The sustainability of the business models of insurers and pension funds offering longer-term return guarantees:
- create an EU-wide monitoring framework of LIRE-related risks for ICPFs.
For each of the objectives set out above, the report identifies specific policy options. For instance, the relevant authorities should continue their efforts to improve the current framework for dealing with distressed banks in Europe to facilitate and ensure the orderly exit of non-viable institutions, in particular small and medium-sized banks, in view also of the need to reduce overbanking and foster system profitability in the LIRE. Relevant authorities are also encouraged to consider eliminating legal obstacles to charging negative rates in their jurisdictions (with no requirement for banks to apply negative rates to deposits or loans).
At this stage, these should not be seen as ESRB recommendations but, instead, as blueprints for medium-term policy objectives. The ESRB may selectively choose some of these proposals to be refined and further developed into more concrete ESRB recommendations.
An Appendix with three analytical boxes and over 50 charts and tables supports the text of the report.
Authors’ note: The authors served as Co-Chairs of the ESRB Task Force on the Low Interest Rate Environment. We are very grateful to Elena Mazza, Secretary to the Joint Task Force, as well as to the other 32 members of the Task Force and a wide range of commentators and contributors.
Acemoglu, D and S Johnson (2007), “Disease and Development: The Effect of Life Expectancy on Economic Growth”, Journal of Political Economy 115(6): 925-985.
Aksoy, Y, H S Basso, R P Smith and T Grasl (2019), “Demographic Structure and Macroeconomic Trends”, American Economic Journal: Macroeconomics 11(1): 193-222.
Backus, D, T Cooley and E Henriksen (2014), “Demography and low-frequency capital flows”, Journal of International Economics 92(Supp. 1): 94-102.
Bernanke, B S (2005), “What Explains the Stock Market's Reaction to Federal Reserve Policy?”, The Journal of Finance 60(3): 1221-1257.
Cochrane, J (2021), “Low Interest Rates and Government Debt”, speech prepared for the IGIER policy seminar, 11 January.
ESRB (2016), Macroprudential policy issues arising from low interest rates and structural changes in the EU financial system, Joint Task Force of ESRB Advisory Technical Committee (ATC), ESRB Advisory Scientific Committee (ASC), and ESCB Financial Stability Committee (FSC).
ESRB (2021), Lower for longer – macroprudential policy issues arising from the low interest rate environment, Joint Task Force of ESRB Advisory Technical Committee (ATC), ESRB Advisory Scientific Committee (ASC), and ESCB Financial Stability Committee (FSC).
Ferrero, G, M Gross and S Neri (2019), “On secular stagnation and low interest rates: Demography matters’’, ECB Working Paper No 2088.
Gordon, R J (2016), The Rise and Fall of American Growth: The U.S. Standard of Living since the Civil War, Princeton University Press.
Gourinchas, P-O, H Rey and M Sauzet (2019), “Global Real Rates: A Secular Approach”, BIS Working Paper No 793.
Karabarbounis, L and B Neiman (2014), “Capital depreciation and labour shares around the world: measurement and implications”, NBER Working Paper No. 20606.
Kiley, M T (2020), “The Global Equilibrium Real Interest Rate: Concepts, Estimates and Challenges”, Annual Review of Financial Economics 2020.12: 305-326.
Rachel, L and L H Summers (2019), On falling neutral real rates, fiscal policy, and the risk of secular stagnation, Brookings Papers on Economic Activity Conference Drafts, March 7-8.
Rey, H (2013), "Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence", Federal Reserve Bank of Kansas City Economic Policy Symposium.
Schnabel, I (2021), “Unconventional fiscal and monetary policy at the zero lower bound”, speech at European Fiscal Board on 26 February.
Summers, L H (2013), Speech at the IMF Fourteenth Annual Research Conference in Honor of Stanley Fischer, Washington D.C.
Summers, L H (2014), “US Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound”, Business Economics 49(2): 65-73.
Thwaites, G (2015), “Why are Real Interest Rates so Low? Secular Stagnation and the Relative Price of Investment Goods”, Bank of England Staff Working Paper No 564.