Low real interest rates: depression economics, not secular trends

Gene Kindberg-Hanlon.

Real interest rates have fallen by around 5 percentage points since the 1980s.  Many economists attribute this to “secular” trends such as a structural slowdown in global growth, changing demographics and a fall in the relative price of capital goods which will hold equilibrium rates low for a decade or more (Eggertsson et al., Summers, Rachel and Smith, and IMF).  In this blog post, I argue this explanation is wrong because it’s at odds with pre-1980s experience.  The 1980s were the anomaly (chart A).  The decline in real rates over the 1990s and early 2000s simply reflected a return to historical norms from an unusually high starting point.  Further falls since 2008 are far more plausibly related to the financial crisis than secular trends.

Chart A: US 1 year real interest rates since 1900

Source: Robert Shiller and author’s calculations
Note: Simple estimate of real rates using 1-year US treasury bill converted to a real yield using the year-ahead CPI outturn.  Model-based estimates of short and long-term real interest rates show similar trends to the above chart (for example, see IMF).

Do secular trends affecting real interest rates fit the data before the 1980s?

Studies proposing a secular fall in real interest rates have generally taken the 1980s as their starting point.  However, the 1980s appear to be an anomaly, as real interest rates were well above rates observed earlier in the 20th century.  The secular trends proposed to be causing declining real rates since the 1980s do not fit the data beforehand.

In Rachel and Smith (2015), around two-thirds of the fall in real rates since the 1980s is thought to be due to a combination of weaker global growth expectations, a falling dependency ratio and a fall in the price of capital goods relative to consumption goods.  The expectation of weaker global growth is said to reduce desired investment for a given interest rate, shifting the investment schedule to the left, while a falling proportion of non-working dependents should increase the savings schedule for a given interest rate.  Finally, a fall in the price of capital goods relative to consumption goods is said to reduce desired nominal investment relative to savings, reducing the real interest rate.

The factors thought to account for the majority of the fall in real rates since the 1980s can explain none of the prior rise in real rates to their abnormally high level.  Global growth was much higher in the 1950s to 1970s than in the 1980s, yet real interest rates were significantly lower on average (Chart B).  The dependency ratio was also higher before the 1980s, providing little explanation for why real rates began to increase following that period.  And the relative price of capital to consumption goods remained steady until the 1980s, in no way contributing to the rise in real interest rates.

Chart B: Secular trends and the real interest rate
Sources: UN, Maddison dataset, Shiller and Eichengreen
Note: Dependency ratio shows ratio of dependents (0-19 and 65+) to those of working age (20-64).  Relative price of capital is an index of the ratio of ratio of capital goods to consumption goods.

Empirical problems with the mainstream economic theory of the determination of real interest rates are not new.  Hamilton et al. find a very tenuous relationship between long-run growth and real interest rates using panel data going back to the 1800s, as have other studies (for example the San Francisco Fed).

Are interest rates determined by loanable funds?

During the last period in which economists feared secular stagnation, the 1930s, Keynes argued that the loanable funds framework for interest rate determination, involving the equilibration of ex-ante savings and investment preferences, was flawed.  Instead, the interest rate should be regarded as the price of money in exchange for less liquid financial assets (see “the ‘ex-ante’ theory of the rate of interest”)

Central banks naturally wield a large influence over nominal interest rates and financial market conditions, and are responsible for maintaining inflation expectations.  Therefore it is to central banks we turn to explain real interest rate developments.   It was central banks’ long-lasting grapple with significant institutional changes following the collapse of Bretton Woods during the 1970s and 1980s, rather than secular trends, that can explain the rise and subsequent fall in real interest rates since the 1980s.

What was different about the 1980s?

To understand why real rates were so high in the 1980s, you must first understand why they were low in the 1970s.  The answer lies in a series of drastic institutional changes that began with the collapse of the Bretton Woods system in 1971.  This system had previously pegged the value of the US dollar to gold, with many other economies in turn pegging the value of their currency to the US dollar.  This “anchor” forced central banks to increase interest rates as inflation increased, so that there would not be a run on their currency.  The collapse of the Bretton Woods system eliminated this anchor, with no immediate inflation-stabilising institutional framework to replace it.  A series of “cost-push” oil shocks (from the oil embargo in 1973 to a further energy crisis in 1979) and “demand-pull” factors, partly as a result of high fiscal expenditure, increased inflation.  Monetary authorities did little at the time to offset these, instead accommodating rising inflation in order to secure growth objectives, and interest rates rose less than one-for–one with inflation (Chart C).

Real rates increased sharply to restore price stability and anchor expectations in the late 1970s.  The introduction of the Humphry Hawkins (1978) Act established price stability as well as growth and employment in the Fed’s objectives.  And the introduction of Paul Volcker as chairman of the Fed led to a much more aggressive inflation targeting regime, with immediately higher real interest rates following his appointment (Chart C).

Chart C: US nominal, real interest rates and inflation

Source: Shiller and author’s calculations

What if central bank credibility can affect real rates?

Re-establishing the credibility of a central bank’s inflation targeting regime is costly, requiring significantly higher real rates initially than in a regime where expectations are already anchored.  Several studies (such as Clarida et al.) have noted that monetary policy appears to have been “passive” in the 1970s, with monetary authorities willing to tolerate inflation in order to maintain high employment and growth.    It is likely that following a decade of high inflation rates, credibility of the central bank needed to be won back in the 1980s before real rates could fall back.

A simple new Keynesian model where expectations of a central bank’s policy rule are modelled can demonstrate this.  In a Davig and Leeper (2007)-style model, where agents believe with some probability that the central bank will become “passive” towards inflation in future periods, accommodating it, central banks will need to raise real rates significantly more to control inflation than in a fully credible regime.  Chart D shows the responses of several key macroeconomic variables to a cost-push shock, such as those seen in the late 1970s and early 80s from oil prices.  When agents assign a low probability to the central bank remaining hawkish towards inflation, real rates must rise by a significantly larger amount in response to a given shock to stabilise inflation.  The required response decreases as credibility improves.

Chart D: Impact of a cost push shock: Two regimes – high and low probability of remaining hawkish on inflation


Given the high initial cost of fighting inflation, with unemployment reaching around 10% and the so-called “Volcker recession” in the early 1980s, it is plausible that central banks only gradually began to earn credibility.  But eventually, coinciding with a broad-based fall in real interest rates to levels more consistent with historic norms in the late 1980s, there was also a fall in inflation, as aggressive policy action led to inflation expectations becoming anchored (Chart E).  Coinciding with this fall in inflation, real rates began to return to previous averages.

 Chart E: Inflation in advanced economies


Financial crisis or slow moving secular trends – what explains low real rates since 2008?

Real rates began to fall again to negative levels in 2009, having stabilised in the 1990s and early 2000s.  But are negative real rates a consequence of the largest global financial crisis since the Great Depression, or secular trends?

A wide literature suggests sluggish growth persists for many years following a major financial crisis before normality is restored.  The resulting increased economic slack is a far more likely candidate for lower real rates than slow moving secular trends.  Reinhart & Reinhart (2010) have noted that since World War Two, per capita GDP growth has fallen by around 1 percentage point a year on average in advanced economies in the decade following a financial crisis.  But many other crises, such as the Great Depression, have seen even larger effects (Chart F).    The slowdown in activity and increase in slack since 2008 is consistent with previous episodes.

Chart F: Median fall below trend per capita GDP growth in the 10 years following a financial crisis

Source: IMF, Maddison and author’s calculations
Note: Great depression distribution (1920-1929 relative to 1930-1939) uses data for 19 advanced economies and 1 aggregate of 14 smaller western European economies.  Global financial crisis distribution (1998-2007 relative to 2008-2016, including IMF forecast values for 2016-7) uses data for 28 advanced economies.  Asia crisis and post-war advanced economy each use data for 4 countries.

It would not be the first time that economists had fallen into the trap of assuming growth and interest rates would remain permanently lower for longer as a result of secular trends following a large financial crisis.  In the late 1930s, Alvin Hansen developed the term “secular stagnation” to describe his concerns that structural factors such as stagnant technological development and weaker population growth prospects would weigh on growth permanently.  We know now that these concerns over secular trends proved misplaced, and played little role in weaker growth.  But there is large uncertainty over the length and depth of the slowdown in growth following a broad-based financial crisis of the severity seen in 2008.  The Great Depression was only ended by rearmament and war, but other financial crises have seen recoveries at or before the 10-year mark.  Are we now at a point in which the effects of the 2008 crisis on interest rates may begin to wear off?

Gene Kindberg-Hanlon works in the Bank’s Global Spillovers and Interconnections Division.

If you want to get in touch, please email us at bankunderground@bankofengland.co.uk or leave a comment below.

Comments will only appear once approved by a moderator, and are only published where a full name is supplied.

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England, or its policy committees.