The forces working to push interest rates lower

To the relief of borrowers and the chagrin of savers, there is no sign that official interest rates will return to the levels they reached before the GFC in 2008.

Despite economic growth, low inflation and a tightening job market, global interest rates remain stubbornly low and show no sign of increasing significantly anytime soon.

Almost a decade after leaping to slash interest rates and pump trillions into the global economy amid fears of financial collapse, the world’s central banks are slowly easing their collective foot off the accelerator. The question is: how far will they go? 

In carefully calibrated moves, flagged well in advance, major institutions including the US Federal Reserve, the European Central Bank (ECB), the Bank of England (BoE) and the Bank of Japan are gradually winding back quantitative easing (asset purchasing) programs and edging their rates higher.

In November 2017, the Federal Reserve lifted its target cash rate – which was as low as 0.13 per cent at the height of the global financial crisis (GFC) – to a 10-year high of 1.5 per cent. A month earlier, the BoE had pushed its interest rate to 0.5 per cent and the ECB had announced that from January 2018 it would halve its bond purchasing program to €30 billion a month. 

However, anyone expecting things to snap back to the way they were before Lehman Brothers collapsed, and the world’s financial system came close to seizing up as the GFC wreaked havoc, are likely to be disappointed. To the relief of borrowers and the chagrin of savers, there is no sign that official interest rates will return to anything like the levels they reached before the GFC in 2008 – at least, not anytime soon.

Indeed, questions are being asked if high interest rates of the kind that once bludgeoned borrowing are now a thing of the past, even though the world has entered a period of solid growth.

Low interest rates: a new normal?

International Monetary Fund (IMF) managing director Christine Lagarde says the global economy has hit a “sweet spot” and predicts it will expand by a healthy 3.9 per cent this year and next.

Importantly, growth is not only being propelled by China and India. While both those economies are expected to grow strongly this year, by 6.6 and 7.4 per cent respectively, and developing Asia as a whole is forecast by the IMF to expand by 6.5 per cent, major developed economies are also joining the party.

The US economy, for instance, is expected by the IMF to grow by 2.7 per cent this year, while the euro zone has emerged from years of weakness to expand by 2.4 per cent in 2017, and is forecast to come close to repeating the performance in 2018 and 2019.

Outside the G7 (Canada, France, Germany, Italy, Japan, the UK and the US) and the euro zone, developed-country growth is even stronger, at 2.7 per cent last year and an expected 2.6 per cent this year.

Even in Japan, the perpetual sick man among advanced economies, the economy expanded at a little more than 1.5 per cent in 2017, although that is forecast to drop to 1.2 per cent in 2018.

As a result, global unemployment is coming down and labour markets in some countries are becoming uncomfortably tight. In Japan, just 2.7 per cent of the labour force is out of work and, in the US, the Federal Reserve predicts the jobless rate will drop below 4 per cent. 

In the UK, unemployment is hovering around 4.2 per cent, while in Germany, where the economy grew by 2.2 per cent last year, only 3.6 per cent of workers cannot find a job.

In the pre-GFC world, such a combination of solid growth and low unemployment would have wages and inflation fizzing, and central banks would be reaching for the brakes. Instead, in most major economies, salaries are soft and prices even softer.

Consumer prices in the US, for instance, were flat in December 2017 and in the previous 12 months grew by just 1.8 per cent (excluding food and fuel, not seasonally adjusted). 

In Australia, underlying inflation was just below 2 per cent last year and although the unemployment rate has dropped to 5.5 per cent and is expected to go even lower, wages increased by just 2 per cent in 2017. The Reserve Bank of Australia (RBA) does not expect either to pick up much in the next two years.

Such outcomes have prompted some economists to speculate that the Phillips curve, which holds there is a predictable trade-off between unemployment and inflation, is dead.

Not time to tighten monetary policy

Although the upsurge in global growth has allayed deflation fears, central banks keen to unwind emergency stimulus measures and restore interest rates to more normal levels are being frustrated by weak inflation and associated concerns that tightening monetary policy too soon could deliver a body-blow to growth.

As the IMF advised in its January 2018 World Economic Outlook Update, “in advanced economies where output is close to potential, still-muted wage and price pressures call for a cautious and data-dependent monetary policy normalisation path”.

The US, with its solid growth outlook, seems better placed than many, and its central bank has reaffirmed its commitment to a gradual tightening of monetary policy, including three rate rises in 2018, as inflation pressures slowly build. 

However, American Enterprise Institute Fellow and former IMF deputy director Desmond Lachman believes the US central bank needs to act much more aggressively. 

“There have been a number of basic changes that should be raising red flags for the Fed that the US economy might be on the verge of overheating,” he says. 

“With the economy at close to full employment, and with it being strongly stimulated by a combination of buoyant equity prices, a slumping dollar and a big tax cut, the Fed has two choices. It can either get itself ahead of the curve by raising interest rates at a more rapid pace than it has been doing to date, [or] it can leave itself at the mercy of the bond-market vigilantes who must be expected to come out of the woodwork at the first sign that inflation is picking up.”

In the UK, BoE governor Mark Carney also thinks the time has come to push rates higher. He says the Phillips curve is making a comeback, as growth among the major economies picks up and price and wage pressures firm.

A combination of healthy business investment, increased government spending, continued quantitative easing by major central banks and the effect of increased corporate bond issuance will all help central banks to raise official interest rates to more normal levels.

Reflecting Carney’s hawkish tone, in February 2018 the BoE’s Monetary Policy Committee flagged the probability it will raise rates sooner and higher than earlier expected.

Same same, but different

Elsewhere, central bankers are more cautious. RBA governor Philip Lowe, for one, does not feel compelled to hike the RBA’s cash rate just because the UK and the US are pushing theirs up.

“Just as we did not move in lock-step on the way down, we don’t need to do so in the other direction,” he says. 

“It’s understandable that some other central banks are raising rates. They lowered their rates by more than us and, in a number of countries, the unemployment rate is now below conventional estimates of full employment, at a time when above-trend growth is expected. Our circumstances are a little different.”

Australia, Lowe says, is “still some way from what could be considered full employment and our central scenario for inflation is for it to remain below the midpoint of the medium-term target range for the next couple of years. The Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy.” 

Japan’s central bank governor is similarly wary about hiking rates too soon – unsurprising given the country’s scarifying battle against deflation in the past 20 years.

Although Japan’s current growth rate of close to 2 per cent is almost double its potential growth rate, and unemployment is down to 2.7 per cent, Bank of Japan governor Haruhiko Kuroda says wages and inflation remain weak. In these circumstances, he says, the central bank will “continue with policies of monetary easing”. 

International economics consultancy Roubini Global Economics forecasts a divergence in official interest rates among countries in the Asia-Pacific, as governments and central banks grapple with different economic challenges.

Malaysia’s central bank, for instance, raised its overnight policy rate to 3.25 per cent in January because of strong exports and increasing domestic demand. However, the consultancy expects authorities in China, Thailand, India and Indonesia to hold rates steady until well into 2019 because of concerns such as high rates of commercial debt, financial market volatility and uneven growth. 

Central banks themselves have not helped in this regard. Very low interest rates and the flood of cheap credit from quantitative easing have encouraged savers looking for better returns to pump their money into asset markets, creating the potential for bubbles.

“There have been a number of basic changes that should be raising red flags for the Fed that the US economy might be on the verge of overheating.” Desmond Lachman, American Enterprise Institute

The Dow Jones Industrial Average briefly reached an all-time high above 26,000 points in January 2018, while in places such as Australia, Hong Kong, Canada and the Philippines, house prices have been growing at double-digit rates.

Jeffrey Ng, Roubini Global Economics chief economist, Asia-Pacific, says high rates of leverage, including in China and South Korea, has central banks concerned that pushing up interest rates will stress household finances and crimp consumption, thereby undermining growth. 

Another worry is the effect tighter monetary policy could have on international competitiveness.

Ng says many Asian central banks are wary that higher official interest rates could cause their national currency to appreciate, making exports pricier, less competitive, and adding to the headwinds buffeting the economy.

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Ageing impacts interest rates

Even as central banks grapple with decisions about whether and when to raise interest rates, deeper forces are at work to force rates lower.

The process of globalisation and intensifying economic integration has expanded markets for capital, goods, services and labour across international borders, increasing supply and bringing prices down.

Carney says these changes, augmented by falling government investment, reduced private borrowing, ageing populations and increasing income inequality have driven global real interest rates down by as much as 4.5 percentage points in the past 30 years. 

Of these forces, the rapid greying of countries and regions –  including China, Japan, western and central Europe, and Russia – could have the most profound and long-lasting effect. Ng says shrinking workforces put a speed limit on growth, and Carney reckons the flood of retirement savings has lopped 1.4 percentage points off global real interest rates since 1990, and will cut them by a further 0.35 of a percentage point by 2025.

Meanwhile, an increasing share of income is going towards skilled workers and those living in countries with weaker welfare safety nets; both these groups tend to save, further weighing on interest rates.

Another financial crisis?

Even as the forces of globalisation and demographics bear down on interest rates, Lachman thinks the world is facing a much more immediate threat.

He has watched with alarm the build-up of equity and bond markets under the influence of very low official interest rates and massive central bank stimulus programs.

Lachman warns that as the US Federal Reserve moves to “normalise” interest rates, it will trigger mass sell-offs of shares and bonds around the world. In response, central banks will once again have to slash target rates and pump in credit.

“The Reserve Bank Board does not see a strong case for a near-term adjustment in monetary policy.” Philip Lowe, Reserve Bank of Australia

“As interest rates go up, the stock market will go down, and we will be back where we were in 2008 and 2009, and interest rates will stay there [at very low levels] for a long time,” he says.

Even if the world manages to avoid a repeat of the 2008 crisis, savers and borrowers alike should be prepared for a world in which low inflation and low real interest rates are the “new normal”. 

Explainer: Why central banks are nervous

The global economy might have hit what the International Monetary Fund considers a “sweet spot” of broad and solid growth. However, central banks are worried that if the recovery falters, historically low official interest rates mean they will not have the crisis-fighting tools they did a decade ago.

The dimensions of the problem are stark. When the global financial crisis (GFC) struck in 2008, major central banks including the US Federal Reserve, the European Central Bank (ECB), the Bank of England (BoE), the Bank of Canada and the Reserve Bank of Australia (RBA) had official interest rates ranging, in some cases, above 7 per cent. 

Interest rates were slashed – by more than 5 percentage points in the case of the Fed and BoE – and several central banks launched massive asset-buying programs to prop up troubled financial markets.

Today, the Fed’s rate, which was 5.25 per cent when the GFC hit, is 1.5 per cent. The ECB’s, at 4 per cent pre-GFC, is 0.0 per cent. The BoE’s, which was at 5.75 per cent, is now 0.5 per cent, while the RBA dropped from 7.25 per cent to 1.5 per cent.

The situation is even worse for the Bank of Japan. Its rate has been at -0.1 per cent for more than two years – effectively penalising customers for saving.

However, persistent low inflation is stopping central banks from choosing to restore official interest rates to more normal levels.

This policy bind has prompted debate about whether it is time for central banks to target higher inflation (so prolonging the current economic stimulus) or to abandon inflation targeting and focus on growth or price levels. 

“We are living in a singularly brittle context,” says former US Treasury Secretary Larry Summers. He warns that if governments and central banks ignore the long-term decline in real interest rates and do not adjust their monetary policy frameworks, “we will put ourselves at risk of very substantially exacerbating the next recession”.

Summers thinks that instead of targeting inflation, central banks should focus on nominal GDP growth and aim to hold it at 5 to 6 per cent.

Former US Federal Reserve chairman Ben Bernanke says the idea is “worth talking about”, but is hesitant to abandon inflation targeting. The situation is not as dire as some portray, he says. 

Even with interest rates close to zero, inflation is still expected to reach around 2 per cent, and experience in the US and Europe shows that quantitative easing, central bank coordination and clear market communications, can stimulate activity when nominal interest rates are close to zero.

Read next: Should companies be taking greater advantage of record low interest rates?


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