Risks to the advanced economies from persistently low interest rates

The National Institute of Economic and Social Research has just published its quarterly economic review and forecast of the world economy, again highlighting the continued mediocre growth of the advanced economies. It is particularly striking that such weakness is continuing despite extremely low interest rates—negative in some cases—which have been associated with the accommodative monetary policies pursued in recent years by the central banks in these economies. Central banks have lowered their benchmark short-term interest rates close to zero, or even to negative levels. They have also taken unconventional measures, including “quantitative easing”, to reduce longer-term interest rates, which have also fallen significantly in recent years, in some cases to zero or below. In September 2016, about 40 per cent of advanced economy government bonds outstanding carried negative yields (see IMF, Global Financial Stability Report, October 2016, Fig. 17), which is unprecedented. However, persistently low or negative interest rates themselves pose risks to the economy. We discuss three such risks. 

The first is the danger of excessive risk-taking by economic agents as central banks try to stimulate demand. This may lead to unsustainable rises in asset prices that will eventually come to grief in market collapses that destabilise the economy. Central banks have continued to argue that while this danger is real, asset market developments have not yet been such as to cause major concern.

A second risk is the possibility of a flight from bank deposits to cash, particularly if deposits carry a negative rate. This could hinder the transmission of monetary policy as well as reduce the supply of bank credit. Thus far, there has been little sign of this occurring. However, if central banks were to push rates even further into negative territory, this situation would be likely to change.

A third risk concerns the effects of low – especially negative – interest rates and a flattened yield curve on bank profitability, and hence potentially on the supply of credit and the stability of the financial system. Concerns about bank profitability have been evident recently in stock markets, especially in Europe, with several banks taking action to reduce their operating costs and shore up their capital positions.

These risks point to dangers that could be involved in pushing accommodative monetary policy further.

But the continuing weakness of demand and activity with near-zero interest rates points to a second kind of risk. If there was an economic downturn in the advanced economies in the near future, central banks would lack the room to cut interest rates by anything like the rate reductions seen in the typical recessions of recent decades.

This carries two major implications.

First, it is important that current economic recoveries not be jeopardised by a premature tightening of monetary conditions.

Second, with monetary policy now increasingly constrained, the case for a more balanced use of policy instruments, including expansionary fiscal policy – particularly through public investment financed by the exceptionally low-cost borrowing now available to governments – and structural policies that boost demand as well as potential output, is now even stronger than on the several occasions when such measures been advocated in issues of the National Institute Economic Review (NIESR) over recent years.

These issues are discussed more extensively in the November 2016 NIER.