In a speech “Low Interest Rate Environments and Risk“, John Simon, Head of Economic Research, RBA discussed the question of whether current low interest rates are a concern, citing for example John Taylor who argued that by keeping interest rates too low between 2003 and 2005 the Fed brought about a search for yield, contributed to the housing bubble and, thus, was a key factor in the financial crisis.
In recent years there has been an increasing concern globally that extended periods of low interest rates pose a problem for economic and financial stability because they encourage excessive risk taking. The immediate cause of the concern seems to have been the experience of the global financial crisis. The standard narrative goes that low interest rates through the 2000s encouraged a build-up of risk taking that caused the global financial crisis. People then look at current interest rates and worry that we might be experiencing the very same dynamic; that history might be repeating itself.
He notes that nominal interest rates have been low for much of the past 400 years. Looking at UK monetary policy interest rates one can see how much of an aberration the 1970s were. From around 1700 they spent a long time at 5 per cent – the sort of level that prevailed during the build-up to the GFC. In the 50 years prior to WWI they ranged between 2 and 6 per cent, with them at 2 per cent much of that time. During the Great Depression and WWII they were similarly low, stuck at 2 per cent until the 1950s.
And yet, despite interest rate settings and circumstances somewhat similar to today, the aftermath of the Great Depression did not lead to another financial crisis. Rates were low, but appropriately so given the weak underlying growth.
He suggests that only when the combination of low nominal interest rates, solid growth and a deregulated banking system arose that the finger of blame started pointing towards interest rates. But, even then, there were differences across countries. While most countries had low interest rates, prudential standards varied. While some countries managed the environment well, this was clearly not universal. Thus, one can conclude that even in buoyant low interest rate environments, appropriately calibrated prudential policy can help to restrain risk taking by financial institutions.
I don’t think low interest rates, on their own, are inherently risky or destabilising. Rather, inappropriately low interest rates – that is, low interest rates during times of strong economic growth – combined with inadequate prudential supervision can contribute to a build-up of risk that is ultimately destabilising. But even if one accepts that low interest rates can contribute to the problem, low interest rates aren’t the indicator one should be looking at. As reflected in the results of the early-warning literature, and also the fact that excessive leverage is commonly associated with financial booms and busts, some sort of credit measure is better than looking at interest rate levels. Credit tends to reflect a combination of the relative speed of growth, the tightness of prudential controls and the tightness of monetary policy, while interest rates alone do a poor job. But even credit is but one indicator of possible problems, so this is not an argument that we should just look at credit instead.
In sum, in 2007 we experienced a combination of factors that each contributed to the financial crisis. The world economy was growing strongly, but contained inflation led many central banks to keep interest rates low. In some economies prudential regulation was clearly inadequate to contain a deregulated banking sector. Together, these contributed to a highly leveraged financial sector. And the rest, as they say, is history.
This of course leads to another observation – in many advanced economies with low interest rates these other conditions are not apparent at the moment. Economic growth is weak, credit growth is generally low, there are many people paying down debt and not many investing – we could probably do with a bit more entrepreneurial risk-taking. (Although, to be clear, we could do with less leveraged speculation.) Furthermore, chastened by the experience of the financial crisis, prudential regulators the world over are raising standards. Here in Australia, a few months ago the Australian Prudential Regulation Authority (APRA) announced that it would be increasing capital charges on some mortgage lending and the major banks have increased their investor loan interest rates to slow growth in line with APRA measures. So, while it never pays to be complacent, there are few early-warning indicators for a financial crisis despite the prevalence of low nominal interest rates. In any case, low interest rates are a poor indicator of future problems and, given currently weak global growth, entirely appropriate. Thus, I think, concern over the current low levels of interest rates expressed by John Taylor and those who worry about the search for yield are probably overdone.
