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The inexorable fall in nominal interest rates

17/05/2016

Marie-Hélène Duprat, Senior Advisor to the Chief Economist

Why are interest rates so low? There are three main reasons. First, the fall in inflation, which currently stands at close to zero. Second, lower expectations for real yields, which could be explained by a number of factors, from the global oversupply of savings (relative to investment) to the deterioration of longer-term growth prospects, caused, for example, by slowing productivity growth or the ageing population. Third, since the crisis of 2008, there has been a sharp rise in net demand for “risk-free” bonds, amplified by the tightening of prudential constraints weighing on financial institutions and large-scale purchasing of public debt by central banks.

What are the effects of low – or even negative – interest rates? On one hand it reduces the cost of borrowing and encourages households and firms to spend more, which should boost growth and help return inflation to positive territory. On the other hand, it leads to the loss of a key instrument of monetary policy when interest rates hit their lower bound (i.e. zero or slightly below zero). Furthermore, negative interest rates are likely to eat into banking profits. Nonetheless, this would depend on the asset structure and composition of the portfolio of activities of each financial institution. Very low interest rates for a sustained period may also have negative repercussions for savers, and in particular, life insurance companies and pension funds. Lastly, low interest rates could encourage excessive risk-taking in a search for yield.