NEWS Release - Stability, equity and monetary policy - Mario Draghi, President of the ECB, 2nd DIW Europe Lecture - German Institute for Economic Research (DIW) - Berlin, 25 October 2016
The most salient feature of the landscape facing monetary policy today is the low level of nominal and real yields everywhere. Among the G7, three countries currently have negative yielding 5-year bonds – Germany, France and Japan – representing 14% of world GDP. And that proportion rises to 22% if we include bonds yielding less than 1%.
Some observers see this as an artificial state generated by the policies of central banks – and argue that it threatens not only economic and financial stability, but social equity too. So what I would like to discuss in my remarks today is why interest rates are so low, and what the implications of those low rates really are. My focus will be in particular on the distributional effects of monetary policy.
Adjusting monetary policy to a falling natural rate
Low yields are not merely a legacy of the crisis that beset the global economy in 2008. Taking a wider view, long-term interest rates have been on a downward trend across the global economy for the better part of the past thirty years (Chart 1).
This trend has certainly had positive drivers, namely the success of central banks in advanced economies since the 1980s in achieving price stability and in anchoring inflation expectations. This has reduced both expected inflation and the inflation risk premium embedded in long-term interest rates. The taming of inflation explains a large part of the initial fall in nominal yields in the 1980s and 1990s.
But there are also more worrying drivers. Behind the fall in nominal yields has also been a fall in real yields. This has been attributed to three main factors.
The first is a secular slowdown in productivity growth across advanced economies, coupled with pessimistic expectations about growth potential in the years to come, which has reduced the expected rate of return on capital. And if that real rate of return falls, it is logical that firms will only be willing to borrow at lower real rates. This is reflected in lower long-term real yields.
The second factor is a global imbalance of saving and investment, which has led real yields to fall even relative to growth prospects. On the saving side, a “global saving glut”, produced among other things by ageing populations, has bid up the price of safe assets at a time when the supply of those assets has been shrinking, thereby compressing real yields. Factors such as a decline in the relative price of capital goods have also led to a fall in desired investment.
And this has been exacerbated by the third factor: the debt overhang in the public and private sectors bequeathed by the financial crisis. This has further raised saving – as all sectors deleverage – and depressed investment and consumption.
As a consequence, the natural rate of interest – which is the real interest rate that balances desired saving and planned investment, at a level consistent with output being at potential and stable prices – has fallen over time, to very low or even negative levels. And whatever the drivers behind this, central banks have to take it into account and cut their policy rates to commensurately lower levels.
Indeed, the way standard monetary policy works is to steer real short-term interest rates so that they “shadow” the natural rate, which keeps the economy in balance and prices stable. When inflation is below our objective and there is a negative output gap, monetary policy has to bring real rates below the natural rate to provide enough demand support. And when inflation is above our objective and the output gap is positive, the reverse is true.
If central banks did not act in this way – that is, if they did not lower short-term rates in tandem with the natural rate – market rates would be too high relative to the real returns in the economy, and investing would become unattractive. The economy would therefore be pushed away from full capacity and price stability. By contrast, by holding market rates below the real rate of return, we encourage the investment and consumption that is needed to bring the economy back to potential.
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