The most comprehensive educational resources for finance

Historically Low Interest Rates: Causes and Explanation

Stanley Fischer, Vice Chairman at Economic Club of New York (October 2016) regarding historically low-interest rates. This article is a summary of his speech regarding the same.

Fischer notes that with the exception of December 2015, the Federal Fund Rate has been low. The policy rates of most major central banks known for their conservative monetary policy are in the negative. Countries too have kept their long- term interest rates low, expecting policy rates to stay low for long.

Why then does the Fed not simply increase their rates? The factors that keep them low are technological and demographic in nature.

The low-interest rates are cause for worry. They are indicative of an economic slow-down. They make the economy more susceptible to shocks that could put it into an economic recession. Cutting of interest rates is the conventional tool central banks use to combat accommodation. Asset purchases, balance sheets and forward purchases can be used, though low-interest rates are favoured.

Financial stability is the third casualty of low interest rates. It makes it difficult for institutions to build capital buffers as investors reach for yield. It may seem like these are three very good reasons to hike interest rates, but the Fed has kept them low to maintain aggregate demand with the twin goals of price stability and maximum sustainable employment.

Real interest rates can be defined as the price that equilibrates the economy’s supply of saving with the economy’s demand for investment. Factors that boost saving and depress investment can explain why interest rates are so low.

historically-low-interest-rates

Four factors have affected the balance between saving and investment in the recent years. Gains in productivity and that of the labour force are of high importance. The second factor is an increase in the average age of the population, which is pushing up household savings. The third factor is thanks to the low-interest rates are lower investments. Finally, reduced economic growth outside of the U.S has led to reduced interest rates.

Fischer goes on to assess the impact of low-interest rates empirically. Fischer uses the results of simulations on the econometric model used by the Fed known as the FRB/US model. He notes that the findings of the model point to a lower rate of growth in labour productivity. He says:

One broad measure of business-sector productivity has risen only 1-1/4 percent per year over the past 10 years in the United States and only 1/2 percent, on average, over the past 5 years. By contrast, over the 30 years from 1976 to 2005, productivity rose a bit more than 2 percent per year.

This is on account of a slower rate of innovation, which leads to fewer opportunities to invest in.
Lower productivity growth leads to a fall in future prospects household income, therefore reduced consumption and higher savings. This situation in which there is higher saving but lower investment keeps interest rates low.
An ageing American population means a dip of ¼ percentage point from the labour force in coming years. Ficher cites the Summary of Economic Projections of the FOMC, in which the median value for the rate of growth in the real gross domestic product (GDP) in the longer run is just 1-3/4 percent, compared with an average growth rate from 1990 to 2005 of around 3 percent. This slowdown will result in a reduction of 120 basis points from the longer-run equilibrium federal funds rate.

The ageing population will also boost savings. Their above average saving rates have led to a pushing down of equilibrium federal funds rate relative to its level in the 1980s by as much as 75 basis points.

Investment in the US has also reduced. A climate of global uncertainty has led to doubts about financial stability. This has led to lower investments. Secondly, the economy is less capital-intensive than it was earlier.

How will this change? An improvement in the risk taking ability of the investor needs to happen. In his opinion, Fischer says:

…a rebound in investment would raise the equilibrium funds rate by 30 basis points, according to the FRB/US model. In addition, higher investment would improve the longer-run growth prospects of the U.S. economy, although the effects in this particular case are fairly small, with real GDP growth about 0.1 percentage point higher on account of the higher investment.

The government according to Fischer keeps its eye on long-term growth. Its priority at all times is to encourage private investment, improved public infrastructure, better education, and more effective regulation that is likely to promote faster growth of productivity and living standards. To achieve this purpose interest rates follow.

Try our courses on Data Science for Finance. JOIN FREE

Leave a Reply

Your email address will not be published. Required fields are marked *

Name *