Before the Covid-19 pandemic, low and yet decreasing interest rates were seemingly understood to be with us for a long time. Paul Schmelzing (Bank of England, Staff Working Paper No. 845, Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018, Paul Schmelzing, January 2020) analyzed interest rates over the very long run and even suggested that there was a very long-term trend towards lower and lower interest rates "[...] since the major monetary upheavals of the late middle ages, a trend decline between 0.6–1.6 basis points per annum has prevailed [...]". However, his paper provides no explanation for this trend, making it hard to understand if the drivers of this trend do really still exist. The explanation for such a very long-term phenomenon, would obviously also have to be very long-term, e.g. something like a continuously increasing efficiency of markets.
What determines interest rates? The obvious determinants are supply of funds for loans and demand for taking out loans. A further determinant is the behaviour of central banks. By managing their balance sheets and setting interest rates at which they are lending, they can influence demand for savings and demand for taking out loans.
In the past I found the following reasons in various papers related to the question of enduring low interest rates:
Reasons for a decreasing demand for taking out loans:
- The demographic situation, with relatively fewer younger people requiring loans.
- A shift of private sector activity away from loans. This shift is caused by a changing focus of the private sector towards service industries, which may require less investment. On the other hand this is caused by a changing focus towards industries which don't lend themselves to the structure of loans, e.g. technology businesses, with missing collateral and a longer term outlook towards profitability.
Reasons for an increasing supply of funds for loans:
- The demographic situation, with relatively more older people holding savings.
- An increasing wealth and income inequality, with wealthier people deriving a declining utility from consumption and therefore having a higher propensity to save rather than to consume.
- An increasing rate of savings and the scarcity of safe assets in developing countries.
Frequently productivity is discussed in the context of declining interest rates. A fact is that productivity growth has been declining in advanced economies for decades and recently also in aggregate in emerging economies (Dieppe, Alistair, ed. 2021. Global Productivity: Trends, Drivers, and Policies. Washington, DC: World Bank. doi:10.1596/978-1-4648-1608-6.). On the other hand, there is talk about artificial intelligence and the "Robocalypse", which should result in a productivity increase, if economies manage to handle the structural change and keep people employed. High productivity growth is considered by many to be a driver of higher interest rates, as higher productivity results in a higher return on capital increases. However, it has also been argued that low interest rates may be driving low productivity growth (Banque de France, The Circular Relationship Between Productivity Growth and Real Interest Rates, Antonin Bergeaud, Gilbert Cette, Rémy Lecat, October 2019, WP #734). The rationale being that private sector ventures don't have to put a lot of effort into productivity to maintain their status as a reasonable investment in a low interest rate environment. In summary it seems murky what will happen to productivity growth.
This was the outlook before the start of the Covid-19 pandemic. What changes have there been since?
- In the beginning of the pandemic significantly increased asset purchases conducted by central banks were decreasing the demand for taking out loans in the public market.
- Governments have significantly increased their spending resulting in an added demand by the government for loans.
- The pandemic has caused manifold production and productivity problems, resulting in an increase in inflation. Putin's invasion of Ukraine is exacerbating supply problems, which go beyond the temporary friction experienced during the course of the pandemic.
- Because of the high level of inflation both the ECB and US Fed have announced a slow down or stopping of asset purchases. The US Fed has started to increase their interest rates and laid out a schedule of further interest rate increases.
What does this mean for interest rates in the future?
- very likely short-term interest rates will continue to increase at least until inflation is under control. The US Fed's projection ("dot plot") suggests an increase of the federal funds rate to just under 2% at the end of 2022 and around 2.75% at the end of 2023 compared to a rate of 0.08% at the beginning of 2022.
- very likely long-term interest rates will continue to increase at least until inflation is under control. The US Feds and ECBs asset purchases involve securities with short and long maturities. Assuming government will at least maintain their debt levels (and at historically low debt serving cost, there is really no indication they would change), if those asset purchases slow down, this will create a demand for taking out loans in the public market and will have an impact on a broad range of maturities. The value of securities on the balance sheets are substantial with roughly one third of GDP in the US and the Euro area. If balance sheets were to be completely reduced over twenty years, very roughly, this would mean an additional 1.5% of GDP added to the demand for taking out loans.
- central banks may resume asset purchases once they have brought inflation under control, but combined with increased government spending and debt, this seems to be a potential long-term driver of higher interest rates. It is not clear to me to which degree this balances out with the previously described drivers towards lower interest rates.
In summary, it seems pretty clear that both short-term and long-term interest rates in the short-term will increase. Less clear to me is, for how long long-term interest rates will keep increasing and for how long they will stay at an elevated level.