Low-Interest Rates: Origins and Implications

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The global interest rates have declined significantly over the last two decades. Specifically, many advanced economies have witnessed an astounding decrease in interest rates. In developed nations, interest rates are estimated to have declined by 4 percent in the last two decades. The decrease represents a significant drop that has persisted during and after the global financial crisis. Although some economists argue that the global financial crisis caused it, the decreasing interest rate yield in the last ten years shows a negative interest rate trend. The decreasing interest rate began in the 1990s (Geneva Report, 2014). The decreasing interest rate has affected all countries irrespective of their geographical locations. According to the Geneva Report, the decreasing interest rates began before the global financial crisis.

The Geneva Report is optimistic that the trend will reverse after a broad analysis of the timescale over which the interest rate is expected to rise. The Geneva Report noted that countries could learn from Central Banks how to prevent low-interest persistence rates. Therefore, this paper seeks to analyze the factors that are responsible for the decreasing interest rates and some potential implication. Moreover, it discusses strategies that can be implemented by policymakers to overcome this challenge. For instance, this paper concludes that the global decline in interest rate has been accelerated by the high propensity to save and low propensity to invest.

The decreasing interest rates in advanced economies can be traced back in the 1990s. Gao, Wyman, Sella and Przeworski (2016) argue that it would be shortsighted to think that the interest rates trend will rebound in the short term (p. 7). The current trend shows that interest rates have decreased significantly, and in some countries, the nominal interest rate is mildly negative. In many countries, the high inflation rates have supported thus this trend driving interest rates high. Although the current interest rate trend might rebound, Bohn (2011) believes that policymakers must implement strategies that will boost high-interest rates such as fiscal and capital market policies (p. 7). However, some economists believe that the current trend is expected to rebound especially due to the aggregate propensity to save decreasing as the middle class starts to retire. Picou (2014) believes that this process has already begun where the middle-class has started to spend more as they reach their retirement age (p. 4). Although the Geneva Report and some economists are optimistic that interest rate will rebound, the time scale for such a manifestation to occur is highly uncertain and will be determined by policies that will be implemented.

The decreasing interest rate is supported by the increasing propensity to save. In particular, the declining fertility and increased longevity show that people are aging almost in every country. The saving pattern has changed significantly over the last two decade due to advancement in Medicare, science and high living standards. The expected life span has increased which implies that people need to save more to match their retirement age. However, evidence shows the opposite. For instance, according to a report by OECD, the retirement age for men in 1971 was 63 years compared to 61 in 2010. The higher savings required to maintain individuals after retirement has led to low-interest rates because people save more than they spend. Moreover, after the post-war era, many couples now opt to have fewer children, which have resulted in increased life span. Consequently, the increased lifespan has a direct impact on aggregate savings. Briglevics and Schuh (2014) hold the view that the longevity of life has resulted in complex saving pattern that are driving interest rates low. When people keep excess savings, financial institutions are likely to drive interest rates low to encourage borrowing. This trend has persisted over the years driving interest rates low.

The decreasing interest rate is caused by a decreasing propensity to invest. The past two decades have witnessed a slow growth rate in the number of the middle class. This shows that the current demographic has a low capital intensity of growth that is exerting a downward shift in interest rates.

The declining interest rates have proven challenging for policy makers since they cannot influence the spending behavior of the economy. For instance, the Geneva Report argues that the current working class (who are the majority) will start spending their money when they retire which will cause interest rates to rebound. However, a critical analysis of the spending behavior shows that few people will be willing to borrow when they retire. Therefore, the expectation that interest rates will rebound very soon is incorrect. Moreover, policymakers cannot be able to influence spending behavior of consumers in the economy.

Economists and policymakers have argued that the only prudent way to prevent interest rates from decreasing further is through the implementation of monetary policies. Kananu and Ireri (2015) noted that if interest rate persists, fiscal policies should be applied as the line of last defense (p. 367). This is because the risk-return trade-off will be unfavorable if low-interest rates persist. The rate at which interest rates will rebound will be highly dependent on the long-term fiscal policies implemented by policymakers. Specifically, policymakers must encourage late retirement because it will give people an assurance of household safety thus reducing the aggregate propensity to save.

Policies to overcome low-interest rate

The best policies that can be employed to overcome declining interest rates are monetary policies and capital market control measures. Fiscal policies have been successful in preventing declining interest rates. The Central Banks have the ability to control interest rates by altering official interest rates to control demand and supply in the economy. These policies have been active in the UK where the government adjusts interest rates to trigger inflation that is consistent with the Central Bank inflation target. The UK Central Bank has an interest rate target set at 2 percent that is used to control demand and supply in the country. When demand increases, the Central Bank triggers inflation, which rises above 2 percent. However, if supply tends to fall, the central bank will lower interest rates, which results in the inter-lower inflation rate.

Monetary policies are active in both advanced and developing countries. If these policies can be implemented globally, the current trend in interest rates can be managed easily. However, Maddaloni and Peydró (2011) argue that the narrative of the best inflation rate is practically impossible (p. 2145). They noted that the interest rate would still rebound back to declining trend since an appropriate inflation target is not achievable. Consequently, the low natural interest rates will constrain the Central Banks choices. For instance, the Central Bank of Japan tried to implement monetary policies to minimize declining interest rates. However, the economy was trapped in a deflationary crisis that was hard to escape. When the economy is in deflation, interest rates increase raising the burden of debt. Although the intention of the government would be to stimulate economic growth, the debt deflation spiral can lead to bankruptcies and less investment. Moreover, the monetary policies do not apply strictly; they have failed to reduce the impact of decreasing interest rates.

The capital market can be used to prevent excessive risk taking and market bubbles that prevent interest rates from falling. However, this notion has been sharply criticized by Love and Miller (2013) who suggested that any capital market mechanism to increase interest rates would fail due to the high indebted households and businesses in the economy. The vulnerability of the capital market to low-interest rates would still prevail.

Conclusion

The declining interest rate began in the 1990s that were characterized by a decreasing interest rate yields. The decreasing yield was associated with low real interest rates, and then a decrease in the inflation rate. The decreasing interest rate is supported by the increasing propensity to save because the saving pattern has changed significantly over the last two decades because of improved medical facilities and high living standard. Moreover, the expected life span has increased which implies that people need to save more to match their retirement age. Consequently, the interest rate declines significantly as the propensity to save increases.

References

Bohn, H 2011, Fiscal Policy and the Mehra-Prescott Puzzle: On the Welfare Implications of Budget Deficits When Real Interest Rates Are Low, Journal of Money, Credit & Banking (Ohio State University Press), vol. 31, no. 1, pp. 1-13.

Briglevics, T, & Schuh, S 2014, U.S. Consumer Demand for Cash in the Era of Low-Interest Rates and Electronic Payments, Working Paper Series (Federal Reserve Bank of Boston), vol. 13, no. 23, pp. 1-36.

Eguren-Martin, F, & McLaren, N 2015, How much do UK market interest rates respond to macroeconomic data news?, Bank of England Quarterly Bulletin, vol. 55, no. 3, pp. 259-272.

Gao, Z, Wyman, MJ, Sella, G, & Przeworski, M 2016, Interpreting the Dependence of Mutation Rates on Age and Time, PLoS Biology, vol. 14, no. 1, pp. 1-16.

Geneva Report, 2014. Low for Long? Causes and Consequences of Persistently Low Interest Rates, Web.

Kananu, E, & Ireri, J 2015, Effects of operational costs on lending interest rates of commercial banks in kenya, Journal of Business, Economics & Finance, vol. 4, no. 3, pp. 363-373.

Maddaloni, A, & Peydró, J 2011, Bank Risk-taking, Securitization, Supervision, and Low Interest Rates: Evidence from the Euro-area and the U.S. Lending Standards, Review of Financial Studies, vol. 24, no. 6, pp. 2121-2165.

Picou, A 2014, Interest rates are sticky: implications for the yield curve, Academy of Accounting & Financial Studies Journal, vol. 18, no. 1, pp. 1-10.

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Low-Interest Rates: Origins and Implications

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