EconomyIssue 04 - 2023MAGAZINE
GBO_ Zero Interest Rate

The ‘Zero Interest Rate’ myth

While the United States can boast of it avoiding a recession, there are no chances of interest rates coming down to anywhere near zero

While the COVID-19 pandemic has become a thing of the past, the global economy is battling the fallouts of the Russia-Ukraine war in the form of supply chain disruptions. International Monetary Fund chief Kristalina Georgieva has been reiterating that the global growth prospects will remain weak, as inflation is likely to remain higher.

Russia has pulled out of the Black Sea grain deal, while India has banned its rice export to control its domestic inflation. Experts believe that these moves may result in a global food crisis, thus fuelling inflation further.

“Under our baseline forecast growth will slow from last year’s 3.5% to 3% this year and next, a 0.2% points upgrade for 2023 from our April projections. Global inflation is projected to decline from 8.7% last year to 6.8% this year, a 0.2% point downward revision, and 5.2% in 2024,” stated a July 2023 report of the IMF.

IMF also observed that the advanced economies, especially the ones in Europe, will see a sharp deceleration in their GDP growth. The region, whose sky-high inflation and the cost-of-living crisis, started in 2022, are cooling off now, has seen 20 of its countries slipping into the recession.

The IMF believes that the lion’s share of the global GDP growth in the coming days will come from emerging markets and developing economies. Asia has some of these economies. However, China is facing deflation now, with its post-COVID recovery going into a tailspin.

Monetary policies under the scanner

Even though inflation is slowing down, the pace is not matching the expectation levels of the central banks worldwide. Most of them persist with the tested formula of monetary policy tightening, which is slowing the growth of credit to the non-financial sector, increasing households’ and firms’ interest payments, and putting pressure on real estate markets.

In the United States, excess savings from the COVID-related transfers, which helped households weather the cost-of-living crisis and tighter credit conditions, are depleting at a faster pace. In the United Kingdom, every round of interest rate hikes from the Bank of England is resulting in mortgage payments getting costlier.

The IMF sees core inflation (excluding energy and food prices), to decline gradually from 6% in 2023 to 4.7% in 2024. For advanced economies, the ratio may remain almost unchanged at a 5.1% annual average rate by 2023 end, before declining to 3.1% in 2024. So, expect the central banks not to go loose on the monetary policy front.

The only respite has been the global labour market, where the overall employment levels have surpassed their pre-COVID levels in many countries. However, this is offset by the fact that wage inflation is failing to keep up with price inflation.

Era of zero interest rates gone?

Talking about the negative impact of monetary policy tightening, no one can forget about the failure of the United States-based Silicon Valley Bank and the resultant banking crisis in the world’s largest economy. Banking industry stakeholders and analysts believe that the Federal Reserve interest rate increases impacted sectors like technology, cryptocurrency and banking in 2022.

In 2021, when interest rates were near zero in the US and the UK and slightly negative in the eurozone and Japan, the general belief remained that the rate would remain low indefinitely.

“Astonishingly, as recently as January 2022, investors put the probability of rates in the US, eurozone and the UK rising above 4% within five years at only 12%, 4%, and 7%, respectively. After adjusting for expected inflation, real interest rates were negative and projected to stay that way,” Jeffrey Frankel, a professor of capital formation and growth at Harvard University, perfectly summed up this sentiment.

Jeffrey also pointed out that despite the central bank’s aggressive monetary tightening; real interest rates remained significantly negative until late 2022, as long-term rates increased more moderately than short-term rates.

“By October 2022, the yield curve had inverted, signalling that financial markets were expecting central banks to reduce short-term rates in the near future. This sentiment stemmed from the widespread expectation that the US and global economies would enter recession,” he stated further in his article for The Guardian.

Professor Jeffrey believes that with monetary policy tightening, real interest rates have also moved into positive territory. While the United States can boast of avoiding a recession, there are no chances of interest rates coming down to anywhere near zero.

In 2021, economists believed that the “neutral” real interest rate had fallen below zero and they backed the trend to be a long-term phenomenon, with occasional fluctuations like the interest-rate spikes during periods of unusually expansionary fiscal policy.

“Given the Fed’s 2% inflation target, the zero real interest rate seemed to imply that the equilibrium nominal interest rate should fall to below 2%, on average. But US nominal interest rates cannot fall into negative territory, owing to the so-called zero lower bound,” Professor Jeffrey stated further.

During the same year, in Europe and Japan, nominal interest rates fell slightly below zero. Jeffrey says that if the equilibrium real interest rate was negative and the effective lower bound on nominal rates was close to zero, then the global economy would be in serious trouble.

Then, the monetary policy would have been too tight to achieve the economy’s equilibrium rate of growth in terms of the GDP. The responsibility for maintaining full employment would thus have to revert to fiscal policy. Professor Jeffrey summed up the situation with the “secular stagnation” hypothesis, popularised by the former US treasury secretary Lawrence H Summers in 2013.

Finding the silver lining

Professor Jeffrey stated that chronically low real interest rates can make elevated levels of public debt more sustainable. Governments could operate with primary budget deficits and still manage their debt, as it would decrease relative to GDP over time.

“With interest rates having risen, however, the US debt is suddenly a problem again. The debt-to-GDP ratio is expected to resume its upward path from here on out. This was one of the reasons that Fitch Ratings downgraded US debt from its longstanding AAA credit rating on 1 August. The global rise in real interest rates has also worsened debt problems elsewhere, especially in developing countries,” he stated further.

Short-term rates in the United States had been near-zero for nine of the previous 13 years, from 2009 to 2015 and again from 2020-21. Similarly, eurozone rates had been at or below 1% since 2009 and dropped below zero in 2015. In Japan, interest rates have remained under 0.5% since 1996. Some of the countries’ nominal and real interest rates had been trending downward since at least 1992.

Professor Jeffrey explained this phenomenon with factors like slowed productivity, demographic shifts, growing demand for safe and liquid assets, rising wealth inequality, lower capital-goods prices, and possibly a savings glut coming from East Asia.

Talking about Lawrence H Summers, former US treasury secretary argued in 2018, that the country is “likely to have, by historical standards, very low rates for a very large fraction of time going forward, even in good economic times.”

Two years after, as COVID hit the United States, Summers, jointly with Jason Furman, reiterated that “real interest rates are expected to remain negative”.

And Summers is not alone. In 2022, the former IMF chief economist Olivier Blanchard remarked, “The long decline in safe interest rates stems from deep underlying factors that do not appear likely to reverse anytime soon.”

As per the IMF, interest rates in major economies will likely fall in the future because of low productivity and ageing populations, as the monetary body saw the increases in borrowing costs as a “temporary” one once high inflation is brought under control.

Developed-nation central banks may see real rates returning to near-zero, JPMorgan Chase Chief Economist Bruce Kasman stated earlier this year.

Professor Jeffrey expects a section of the monetary economists to expect interest rates to revert to zero, while being overly influenced by the dramatic shifts of 2008-21.

“While I cannot predict the future, I am sceptical that interest rates will return to zero anytime soon. If this assessment is correct, it bodes well for monetary policy, which would be less constrained than previously. But high real interest rates are bad news for fiscal policymakers, who could find themselves once again constrained by unsustainable debt-to-GDP ratios,” he concluded.

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