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.

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:

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