News Release - The challenge of low real interest rates for monetary policy Lecture by Vítor Constâncio, Vice-President of the ECB, Macroeconomics Symposium at Utrecht School of Economics, 15 June 2016
Ladies and gentlemen,
I warmly thank the organisers for inviting me to the Utrecht University Macroeconomics Symposium, a prestigious event dedicated this year to the low interest rate environment. Low interest rates are prevailing in advanced economies where a third of public debt is in negative territory and deposit facility policy rates are negative in several of them. Over the past decades, across major advanced economies both short- and long-term interest rates have experienced a significant decline and are currently at historical lows (see chart below on Long-term interest rates).
In 1980, long-term interest rates stood at 11.4% in the U.S. and 8.5% in Germany. On average, over 2016 they have been about 1.9% and 0.3%, respectively and at about 0.3% for the euro area as a whole. Short-term interest rates have witnessed an equally dramatic fall: in 1980 the interest rate on three-month Treasury securities stood at 11.4% in the U.S. and 6.4% in Germany; this year it has averaged about 0.3% in the U.S. and minus 0.5% in Germany. In the euro area, the overnight interest rate has been minus 0.3%. A striking feature of the current environment is the extent to which interest rates are in negative territory at different maturities across so many advanced countries (see chart below on Sovereign debt yields). For example, yields in Japan up to ten years are negative, and in the case of Switzerland this extends to 15 years.
Why are interest rates so low? Is monetary policy responsible?
Answering these questions is of crucial importance. Understandingly, low interest rates are generating a degree of apprehension in some quarters about the potential negative implications for savers and for the financial industry, due to the compression of interest income.
A superficial, impulsive answer is that rates are low because monetary policy keeps them low. However, in reality, low rates are the result of real economy developments and global factors, some of which are of a secular nature and others relate to the financial crisis.
The concept of a real equilibrium interest rate
To fully understand the present situation, it is useful to invoke the concept, controversial as it may be, of an equilibrium (or neutral) real interest rate, determined by long-term real economic factors and independent from monetary causes. It is based on the idea that there are real economic forces that lead the economy to long-term equilibrium at full employment with stable inflation. The role of monetary policy should therefore be to steer policy and market rates to that equilibrium rate. The concept assumes therefore that money, as well as finance, are neutral in the long run, and only act as devices that facilitate contemporaneous and intertemporal transactions. Many general equilibrium models operate reflecting this vision, which may be difficult to square with economies at present, on the back of the staggering permanent loss of output resulting by the recent financial crisis.
The importance of the concept of a real equilibrium interest rate is that it provides a sort of anchor to a monetary economy. In reality, the concept defines an optimum to which the economy would move spontaneously in the long run if wrong policies would not disturb it. The concept was introduced in 1898 by Knut Wicksell as he became aware that in a credit-dominated economy, where banks create money, the traditional quantity theory of money could not explain inflation. He therefore introduced the theory of a natural real rate of interest, linked to the marginal productivity of capital that, in combination with market interest rates, would determine price dynamics. Prices would increase if market rates were below thenatural rate, and would decrease should the opposite be the case. As market rates are influenced by monetary policy and somehow related to monetary aggregates, he presented his theory as a reformulation of the quantity theory of money adapted to a credit/money economy. As he wrote in his book “Interest and prices”: “There is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise or lower them. This is necessarily the same as the rate of interest which would be determined by supply and demand if no use were made of money and all lending were effected in the form of capital goods. It comes to much the same thing to describe it as the current value of the natural rate of interest on capital.”[1]
The connection with the productivity of capital in production in physical terms was kept in the loanable funds theory of the interest rate when it refers the forces of “productivity and thrift”. Keynes, in his 1930 Treatise on Money, uses the concept of the natural rate but abandons it in the “General Theory” as he introduces the concept of equilibrium at different levels of employment rejecting the idea of real self-equilibrating forces and underlining the importance of monetary factors (the liquidity preference theory) in determining the interest rates even in the long term. As a result, some Keynesians and especially all post-Keynesians reject the notion of the naturalreal equilibrium interest rate.[2] The link with the real productivity of capital also contributed to that rejection after the famous controversy between the two Cambridge Universities (U.K. and U.S.) in the 1960s and 70s about the possibility of aggregating different capital goods in a capital variable with prices that need an interest rate to be calculated, when, at the same time, the interest rate was supposed to depend on the real productivity of capital.[3]
The idea of the real equilibrium or natural rate disappeared from monetary theory and policy during the time of the controversy between monetarists and Keynesians as also Milton Friedman did not believe in the concept. In his 1968 paper Friedman wrote: “What if the monetary authority chose the "natural" rate – either of interest or unemployment – as its target? One problem is that it cannot know what the "natural" rate is. Unfortunately, we have as yet devised no method to estimate accurately and readily the natural rate of either interest or unemployment. And the "natural" rate will itself change from time to time. But the basic problem is that even if the monetary authority knew the "natural" rate, and attempted to peg the market rate at that level, it would not be led to a determinate policy.
The "market" rate will vary from the natural rate for all sorts of reasons other than monetary policy.”[4] As the empirical instability of money demand functions contributed to the demise of Friedman’s monetarism based on monetary aggregates, the concept of the real equilibrium rate in a Wicksellian sense re-emerged by the hand of Michael Woodford and Lars Svensson, when both created the theory of inflation targeting monetary regimes. Woodford even titled his 2003 book as “Interest and Prices” to underline the relation to Wicksell.[5] Monetary aggregates were substituted by interest rates as the monetary instrument of choice, with monetary policy subject to a quantitative inflation target. As the real equilibrium rate is unobservable, as in the case of Wicksell, evidence that the policy and market rates were deviating from the natural rate would be given by the change in inflation. The policy response was then to increase or decrease policy rates accordingly, to address the problem. This Wicksellian approach, at the centre of the inflation targeting theory, can also be found in optimal rules extracted from new-Keynesian macro models as well as in the Taylor-type monetary policy rule in which the intercept is set at the real equilibrium interest rate level.
The importance of this background is that monetary policy needs to shadow the equilibrium rate in order to meet its stability mandate. If the real equilibrium rate is decreasing then failure to accompany it would leave the economy with too high borrowing costs with respect to the return on investment. This would discourage investment and consumption and generate recessionary and deflationary pressures.
Monetary policy is therefore part of the solution and not part of the problem. By ensuring low interest rates, monetary policy is supporting and accelerating the recovery and with this, the return to a normalisation of inflation and subsequent normalisation of interest rates. This starts to be visible in the U.S. where interest rates have started to increase.
To demonstrate that monetary policy did not create per se the environment of low interest rates but is rather responding to a declining real rate of equilibrium, we need to have some empirical idea about a concept that is unobservable. There exist, however, many different methods to try to estimate this unobservable rate. One approach can be based on the existing medium- to long-term market interest rates, assuming that the markets are influenced by the concept of a long-term equilibrium real rate. Methodologies can then try to extract that wisdom of markets by using filters or models to decompose the actual interest rates. Other methods are more theoretical and model-based, building on the possible determinants of a real equilibrium interest rate. I will present some estimates using both types of approaches.
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