Low Interest Rates Forever?
Nominal and real interest rates have been falling for 30 years now. What is driving this trend, and can we expect to see a reversal sometime soon?
Last December, the United States Federal Reserve (Fed) raised its key interest rate for the first time since June 2006. The undeniable question now is whether that move signals a fundamental change. That is because interest rates around the world, both short-term and long-term, have been falling for the past three decades. Today, they have virtually hit rock bottom. However, one thing is certain: By setting their prime rates, central banks help determine the level of short-term nominal interest rates. Through their policies, they also influence the level of inflation and inflationary expectations, which, in turn, affects interest rate levels. Real interest rates, which are the nominal rates minus inflation and the figure of actual relevance to the economy, are, however, also determined by numerous other economic and structural factors.
The long-term downward trend in real interest rates (see chart) can be understood primarily as the supply-side and demand-side interplay between a strong increase in worldwide savings volume and a slowdown in capital spending. For example, in the late 1990s and above all between 2000 and 2007, the rate of savings in emerging markets rose sharply compared to their gross domestic product (GDP), especially in China and other Asian countries as well as in oil-exporting nations. That more than made up for the decrease in government and, in some cases, even personal savings in industrialized nations. That is because the amount being saved in developing countries beyond their domestic spending flowed into industrialized nations as a net capital export thanks to tighter financial market integration. The main driver behind this "savings flood" was the rapid economic growth in the emerging markets, which led to an increased savings rate as a result of rising incomes. In addition, demographic trends had the effect of stimulating worldwide saving. Empirical evidence shows a positive correlation between the share of the population currently at working age and with a strong tendency to put money aside, and the global savings rate. Thus, the especially high number representing these age groups has helped boost savings in the past few decades.
The growing volume of savings around the world was contrasted with diminishing capital spending in industrialized nations. In particular, that applies to the years after the financial crisis when, against a backdrop of extreme uncertainty and weak demand, the lack of profitable projects put a drag on capital spending. However, there has been a noticeable fall-off in the rate of spending relative to GDP since the 1980s. Among other things, that can be attributed to lower costs of capital goods and the trend towards lower capital spending on the part of governments.
Another factor contributing to falling real interest rates is the broad reallocation of portfolios in favor of government bonds. Emerging markets are chiefly responsible for this trend because they took their foreign currency reserves, which have burgeoned since the beginning of this century, and invested them in more and more government bonds of industrialized nations. Since bond yields fall as demand rises, this development contributed to lower interest rate levels. After the financial crisis hit, many central banks launched quantitative easing programs. That strategy, involving the purchasing of long-term bonds, only exacerbated the trend.
To derive a forecast about future interest rates from these developments, we need to distinguish which of the factors described were caused mainly by the financial crisis and which ones are the result of a structural trend that began before the financial crisis. The first group is made up of the weak capital spending caused by the crisis and the central banks' bond-buying programs. The latter will most likely end at some point in time, and the additional demand for long-term bonds they generate is therefore limited to the programs' duration. Unlike the programs in Europe, quantitative easing in the United States has already come to an end, and the Fed is expected to continue raising its key interest rates gradually over the coming months and years. A large part of the lasting effects of the financial crisis on capital spending is also economic. We can expect them to be overcome slowly but surely in the course of resurging demand. However, the long-term downward trend in capital spending rates in industrialized nations will probably continue to put a dampener on things. The refocusing of China's economy from growth driven by capital spending to consumer spending, plus the fact that economies with aging populations tend to have lower capital spending, also does not lead us to expect a trend reversal resulting from structural change.
Of the factors that affect the savings trend, we believe the "savings flood" in emerging markets will recede somewhat as growth rates slow. For example, the surplus in savings, primarily those in oil-exporting nations, has already fallen. Demographic factors, by contrast, will continue to weaken interest rates, since people tend to save up for a rainy day as they age. Seniors also have a relatively strong preference for safe asset classes. High demand for bonds will continue, partially promoted by ever stricter financial regulation. In summary, it can be said that a slight increase in real interest rates is foreseeable over the medium term, but a trend reversal leading to significantly higher interest rates does not seem very likely.