The Policy Perils of Low Interest Rates: Well before Central Banks Slashed Rates to Fight the Great Recession, Long-Term Market Rates Began Slipping. with No Reversal in Sight, Will Policymakers Lose Their Main Recession-Fighting Tool?

By Drozd, Lukasz A. | Economic Insights, Spring 2018 | Go to article overview

The Policy Perils of Low Interest Rates: Well before Central Banks Slashed Rates to Fight the Great Recession, Long-Term Market Rates Began Slipping. with No Reversal in Sight, Will Policymakers Lose Their Main Recession-Fighting Tool?


Drozd, Lukasz A., Economic Insights


The primary tool that central banks have to fight recessions is to cut interest rates so as to encourage enough borrowing and spending to return the economy to full employment. But as we experienced during the Great Recession, there is a natural limit to how low interest rates can go: It is known as the zero lower bound-or the effective lower bound. When the interest that banks pay on deposits reaches zero, lowering rates further means depositors earn a negative return-in other words, they must actually pay to deposit their money-making it more attractive to stuff cash in a mattress. At that point, monetary policymakers are left without their most tested method of stimulating demand. (1)

The Great Recession marked the first time in the postwar era that the zero lower bound became a relevant constraint for monetary policymaking worldwide. (2) Unable to lower rates any further, the Federal Reserve and central banks in Europe and other developed countries struggled to deliver the additional monetary policy stimulus needed to counteract the deepest economic contraction since the 1930s, finally resorting, as I will discuss, to less proven, unconventional tools such as forward guidance and quantitative easing. Nine years on, economists are still debating the extent to which the lack of the primary monetary policy instrument contributed to the severity of the recession.

Today, the Great Recession is long over. Economic output and employment have recovered, and the Federal Reserve has hiked its policy target rate several times, causing market rates across the economy to begin rising again, to the relief of savers. Yet, to policymakers, the problem of the zero lower bound remains a major concern. What alarms them is that beyond cyclical, policy-induced fluctuations, market interest rates have been trending downward for years, starting long before the last recession, and bringing the zero lower bound ever closer. If this trend has continued through the crisis and current expansion, and many economists believe it has, then policymakers could face the next major recession without a monetary remedy, as occurred with dire results in the Great Depression. Even a mild recession could compel policymakers to turn to the kind of extraordinary interventions employed during the latest crisis, only this time without the extra margin of first responding by cutting rates.

As I will discuss, the nature of the forces behind the decline in interest rates gives little hope for a reversal in the foreseeable future. As I will also discuss, this outlook is prompting study and debate over whether a low-rate environment calls for a fundamentally different approach to monetary policy and to how central banks will fight recessions in the future.

The Global Decline in Interest Rates

Today's exceptionally low interest rates are often blamed on the Great Recession and the economic malaise that lingered in its aftermath. But the picture that emerges from an analysis of the average interest rate across countries shows that the decline very much predates the Great Recession. Accordingly, the low rates prevailing currently may have less to do with the crisis and more to do with the secular global decline in long-term interest rates.

To pinpoint the beginning of this decline, economists follow the evolution of the average inflation-adjusted yield on long-term bonds issued by governments of major world economies that are fiscally sound and open to international capital flows. Averaging long-term government bonds helps filter out forces that are expected to reverse course such as business cycle fluctuations or monetary policy interventions to fight recessions. (4) Tracking the average world interest rate also helps identify the trend because it focuses on movements driven by forces that are common across countries and hence unlikely to be canceled out by international capital flows, which tend to equalize returns across countries in the long run. …

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