Normally during a recovery following a period of prolonged contraction employees produce more products and services to meet growing consumer demand and the gross domestic product (GDP) expands. Unemployment tends to drop, workers are more productive and consumers spend more.
Not so this time around.
It took six years for the per capita GDPs of the US and Japan to bounce back to their pre-crisis levels, and France and the UK only caught back up last year (see France Stratégie’s May 2016 study on global growth prospects for more).
And this despite central banks across the globe spending trillions of dollars purchasing financial assets and the US Federal Reserve and the European Central Bank (ECB) keeping nominal interest rates at close to zero or zero.
The question is how is it low and sometimes negative[*] interest rates have failed to kick-start economic growth and spur inflation, which was at minus 0.1% for the euro area at the beginning of June 2016.
To explore this confounding economic landscape, France Stratégie invited Thomas Laubach, director, Board of Governors of the US Federal Reserve, on June 22, 2016, to discuss whether low natural interest rates are a global phenomenon and if so what the implications for monetary policy are.
Keeping the engine humming
For economists the natural, or neutral, rate of interest is of particular importance as it is the rate at which the economy neither overheats nor contracts – it grows at near full employment, with stable inflation. Put in other words, it is the rate that leads neither to a boom nor a recession.
Laubach pointed to a paper he recently authored with colleague Kathryn Holston of the Federal Reserve and John C. Williams of the Federal Reserve Bank of San Francisco.[†]
Looking at the United States, Canada, the eurozone and the UK, they find both potential GDP growth and natural rates of interest have tended to decline substantially over the past quarter century in all four economies, with the latter falling to “historically low levels”.
Moreover, they posit that declining natural rates of interest are an international phenomenon, with the implications being they are the product of factors that are widespread rather than limited to any one country. They add the effects of this may be amplified by spillovers from one country to another.
Possible explanations could be ageing populations and subsequent slow labour force growth and higher savings rates, plus a slowdown in productivity, all leading to lower output and demand, depressing both inflation and interest rates.
Laubach pointed out that in the US average labour productivity growth has seen its worse five-year performance since World War II.
Indeed, Fed Chair Janet Yellen said as much recently following the Federal Open Market Committee’s decision in mid-June not to raise interest rates.
She stressed “…productivity growth could stay low for a prolonged time, and…aging societies in many parts of the world could depress this neutral rate.” She continued, “…the sense is that maybe more of what’s causing this neutral rate to be low are factors that are not going to be rapidly disappearing but will be part of the new normal.”
Deleveraging, or paying down debt, has also played its part in keeping a lid on interest rates by increasing savings and reducing investment.
Banque de France economist Benoît Mojon reacted to Laubach’s comments by referring to secular stagnation, a structural condition where low interest rates are not enough to spur growth because demand – particularly investment – is simply too weak.
The implications of low natural rates of interest – and consequently low interest rates – run deep. As Laubach and his co-authors point out, monetary policy is effectively constrained for the simple reason central banks have much less leeway in using interest rates to regulate the supply of money in the economy when they are low.
This is notably the case regarding the short term interest rate and the so-called zero lower bound (ZLB) problem, which dictates that when the short term rate approaches zero the central bank doesn’t have much room for maneouvre because rates can’t go below zero. The ECB, the Bank of Japan and several other central banks of advanced economies have been putting this to the test with negative rates – as mentioned above – which were first introduced by the ECB in 2014.
The logic is interest rates below zero will reduce borrowing costs for companies and households, leading to increased demand for credit. Similarly, it will act as a tax on saving, thus discouraging it.
Nevertheless central banks cannot push interest rates too much below zero. Moreover, if the natural interest rate is substantially negative, the economy can get stuck in a low-growth trap.
One of the dangers of this situation is it can push countries to turn to beggar-thy-neighbour policies, for example by tweaking exchange rates to devalue currencies and undercut competitors. This can result in countries exporting, so to speak, their demand shortfall to other countries.
This kind of uncooperative equilibrium was precisely what lead to the spread of the Great Depression in the 1930s.
The ultimate question then is how can policy makers redress this predicament. There are essentially two options on the books: one, engage in structural reforms, such as increasing R&D, boosting education and reforming the labour market; or two, adopt an aggressive fiscal policy in the hope government spending on things such as infrastructure will spark growth.
Which one is the most effective? Or perhaps a combination of the two might do the trick? The jury is still out.
[*] Since June 2014 the ECB’s deposit facility rate has been negative, meaning commercial banks have had to pay the ECB for depositing money with it overnight.
[†] “Measuring the Natural Rate of Interest: International Trends and Determinants,” Federal Reserve Bank of San Francisco Working Paper 2016-11. http://www.frbsf.org/economic-research/publications/working-papers/wp2016-11.pdf