Negative interest rates: How much longer?
The European Central Bank doubled down on 10 March, cutting rates and expanding quantitative easing. The Bank of Japan held their fire in March, after delivering a big surprise with negative interest rates at the beginning of the year. The only major central bank to raise rates recently, the Federal Reserve, scaled back its forecast for further interest rate rises. Overall, the low interest rate environment seen since the financial crisis – and thus much longer than many anticipated – is persisting and increasingly turning negative. With the Eurozone, Japan, Switzerland, Denmark and Sweden almost a quarter of the global economy now has negative official interest rates. Why is this happening and where do we go from here?
Why are interest rates so low?
There are both long-term and short-term, cyclical reasons for lower interest rates.
Major factors in the long-term are aggregate demand for capital and potential economic growth, both of which are in turn impacted by changing world demographics.
Lower population growth and an ageing population are reducing potential growth. An ageing population, expecting to live longer and to have to finance a longer retirement period, is increasing savings, a trend that is compounded by the faltering of traditional pay-as-you-go pension systems. While not only ageing, the world population continues to grow, as is the number of middle-aged people, the part of the population that is most likely to save (Chart 1). China – a high-savings, high-investment economy that has been increasingly integrated into the world economy – is ageing so rapidly that it is in a race to become rich before it gets old and is in the meantime busy saving to cover its mounting retirement (and health-care) costs. Increased savings due to demographics are putting downward pressure on interest rates.
Chart 1. Demographics and China
Past and projected population shares
Additional long-term factors for lower interest rates include:
- Higher risk aversion, which makes lower rates necessary in order to improve incentives for investment if economic growth is not to be compromised.
- Using monetary policy to shield against adverse exchange rate effects, as for example pursued by Switzerland. This policy risks developing into a vicious circle of ever more expansionary monetary policy if other countries are reacting likewise and currency wars and beggar-thy-neighbour policies develop.
- Lower inflation and inflation expectations
This implies structurally lower interest rates in future than before the financial crisis, in boom as well as in bust.
While a bust has been avoided, the world economy has not been booming since the financial crisis (apart from a short-lived catching-up in 2010-11), which is increasing pressure on interest rates in the short-term. In general there are three high-level options to fight a financial and economic crisis such as the one from 2009 onwards: Structural reforms, fiscal policy and monetary policy. While all three have been applied at times since 2009, much of the heavy lifting has been left to monetary policy. The appetite for structural economic reforms has been limited as has the capacity and/or will for fiscal expansion. While economic growth rates have been stabilised and a plunge into deflation so far has been avoided, growth has largely remained disappointing and inflation far below central bank targets, hence the repeated and increasingly bold central bank actions. The current outlook points to stable world economic growth, without much acceleration. A few bright spots – like the US or India – are offset by falling growth in China and anaemic growth in Europe. The short-term, cyclical downward pressure on interest rates is set to continue.
Where do we go from here?
The far-reaching central bank actions are subject to diminishing returns and come with increasingly visible side-effects. These include disadvantages for savers, pressure on pension systems and financial institutions, rising risks of misallocation of capital and asset price inflation. Unfortunately, in the absence of major positive surprises or a much higher contribution from structural reforms and (useful) fiscal expansion, monetary policy is all there is. Expect more of the same in future.
When asked in Q3 2015 when interest rates might rise again in Switzerland, a majority of Swiss CFOs expected this to happen in either 2017 or 2018 (Chart 2).
This now looks increasingly optimistic. The ECB will likely hold rates low for the foreseeable future, even after their quantitative easing program will end. To avoid an appreciation of the Swiss Franc, the SNB is bound to follow the ECB’s lead. The assumption that the low-interest rate environment would only be a short-term crisis instrument after the financial crisis of 2009 has been proved wrong. Likewise, negative rates might well turn out to be less temporary as was widely expected at their introduction last year.
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