Low Interest Rates: The ''New Normal''?


In the wake of the 2008 crisis, interest rates in all the highest rated countries have fallen to unprecedented low levels. And in Europe, many yields have crossed the zero per cent boundary.

This is a truly extraordinary situation; even in the Depression of the 1930s nominal interest rates never fell into negative territory. Many think that these circumstances owe much to central banks, which would have artificially pushed down interest rates. But more plausibly, interest rates are low because the economy is weak.

Economic theory suggests that there is an equilibrium (or ‘natural’) rate of interest, which brings savings and investment into balance. Today, in an era of debt overhang, there is a high likelihood that the equilibrium real rate of interest has fallen to exceptionally low levels, probably well into negative territory. And central bankers are essentially trying to ensure that actual rates align with this theoretical rate so as to return output to potential.

The trouble, however, is that there is a floor beneath which actual nominal interest rates cannot go. This floor is not exactly zero, as we used to think, but just a tad below zero. And because of this floor, actual rates may not be able to fall far enough to reach the equilibrium level, which may explain why the recession that followed the 2008 crisis was so severe and why the recovery that followed has been so slow.

What will happen next? While occasional spikes in yields are inevitable given today’s ultra-low levels, a swift return of interest rates to historical norms appears highly unlikely given the interplay between the lower bound on policy rates and strong deleveraging pressures. The belief that the main economies will operate below potential for quite some time will continue to tie down interest rates for an extended period.

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