As we highlighted recently, global interest rates are lower than they have been for many years, and appear to be locked into a “new normal” which could be close to zero. It is important to understand the mechanisms which have led to this situation, because it is quite possible that the normal assumptions underlying monetary policy (cut rates to stimulate growth; lift rates to control inflation) no longer apply. If this were true, new approaches would be needed, and current unorthodox strategies would need to be re-calibrated. Could it be that demographic shifts and financial sector developments actually explain the shifts, rather than asset price or GDP growth? If true, low rates won’t solve the underlying issues.
The IMF finds that “real interest rates worldwide have declined substantially since the 1980s”. Recent work, (King and Low 2014) estimate a “world real interest rate” and find that the weighted rate has declined from a peak of 4.93% in the first quarter of 1992 to ‒0.48% in the second quarter of 2013. Bernanke (2015) observes the exceptionally low global interest rates, both short- and long-term, are not a “short-term aberration” but a long-term trend.
Timely then, that The Bank for International Settlements (BIS) has just released a staff working paper “Understanding the changing equilibrium real interest rates in Asia-Pacific”, which studies the evolution of the equilibrium real interest rate (i.e. natural or neutral interest rate) in Asia-Pacific.
There are several competing theories behind the decline in equilibrium real interest rates. First, globalisation, especially trade and financial integration have helped forge a global market where domestic factors have begun to play a less prominent role. Financial integration implies that a larger share of global savings is channelled into cross-border financing of investment. In this vein, Bernanke (2005) proposes the “global savings glut” hypothesis, whereby the real interest rate falls to equilibrate the market for global saving as desired saving outstrips desired investment, and saving originating in China and other emerging economies holds down long-term interest rates. Caballero (2006) suggests the existence of a “safe asset shortage” due to rising global demand, as in emerging economies with rapid growth and high savings, there is limited availability of local safe assets in their undeveloped capital markets.
Second, many economists link the apparent decline in equilibrium real interest rates to a “new normal” world of lower potential output and trend growth, manifested in sluggish growth persisting in the major economies following the financial crisis. This has often been attributed to, among other factors, a secular deficiency in aggregate demand, significant financial frictions, unfavourable demographic trends, ebbing innovations, debt overhang, and insufficient structural policies. This may lead to “secular stagnation”, as a low and declining rate of population growth and a slower pace of technological advance result in lower returns, less investment and consumer spending, creating a situation of persistently inadequate demand. This leads to a declining natural rate of interest.
Related to this new-normal slow growth scenario is the “new neutral” thesis focussing on the exceedingly low real policy rates in many advanced and emerging economies alike. McCulley (2003) considers the US natural rate much lower than commonly assumed. In Clarida’s (2014) view, central banks now operate in a world where average policy rates are set well below their pre-crisis levels, a direct consequence of the “global leverage overhang and moderate rates of potential trend growth”. Clarida (2015) suggests that global factors have played a key role, with the lower US neutral policy rate driven by a slowdown in “global potential growth”, and “a persistent excess of global saving relative to desired investment opportunities”.
There have been so far very few attempts to estimate and assess the equilibrium real interest rates for the emerging economies, even less for the emerging Asia. The paper the examines the relationship between the long-run component of real interest rate and those of population characteristics, globalisation, and a range of macroeconomic and financial variables (e.g. credit and asset prices) as well as trend growth in the evolution of the natural interest rates in the region to determine whether these factors may account for the changes over time and differences across countries in the natural rate estimates.
Several results emerge. First, simple estimates suggest that except for China, and also Thailand since 2005, the natural interest rate has declined substantially in Asian-Pacific economies since the early or mid-1990s, by over 4 percentage points on average. In many economies the rate has turned negative. The tendency has become more accentuated in the 2000s, especially since the onset of the global financial crisis and the Great Recession. Second, the natural interest rate estimates vary significantly over time and across the economies. Third, the association seems to be broad and strong between the natural interest rate and the low-frequency trend components of demographic and global factors in Asia-Pacific, but it appears to be weak between the natural interest rate and trends in asset prices, credit-to GDP ratio and trend growth in many economies in the region. In most cases, the natural interest rate does seem to be correlated with broadly measured long-term financial sector development, and trends in saving rate and investment ratio.
Note: BIS Working Papers are written by members of the Monetary and Economic Department of the Bank for International Settlements, and from time to time by other economists, and are published by the Bank. The papers are on subjects of topical interest and are technical in character. The views expressed in them are those of their authors and not necessarily the views of the BIS.
