Neutral Interest Rates

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When central banks started cutting interest rates to near zero after the 2008 stock market crash, they saw it as an emergency measure and thought things would gradually get back to normal. Now they’re wondering what normal means. Eight years later, rates are still super-low, and they’re unlikely to come all the way back. The reason is that the so-called normal or neutral rate of interest — which neither stimulates the economy nor cools it down — has fallen, perhaps permanently. If so, the implications for savers, investors and economic-policy makers will be far-reaching.

The Situation

In November, after Donald Trump’s election as U.S. president, bond yields rose, lofted by his promise of enormous tax cuts combined with much higher spending on infrastructure. Seen in a longer perspective, though, this rise was a blip after more than two decades of steadily falling rates. Average interest rates in 20 developed nations dropped from about 5 percent in 1990 to near zero in 2015, a Bank of England study found. These low rates leave central banks little or no room to cut again if more stimulus is required. Some are already having problems. The U.S., Europe and Japan have tried a variety of tools to jumpstart economic growth, from quantitative easing (buying government bonds in exchange for new money) to negative rates (pushing interest rates below zero). But these policies haven’t been as effective as central banks hoped. And the new fear is that this isn’t just a temporary problem. Why? The world has settled into a pattern of saving more and investing less. Instead of borrowing for expansion or new ventures, corporations are hoarding cash. This falling demand for capital has driven down the neutral rate of interest. And lower interest rates mean tiny returns, hurting investors saving for college and under-funded pension systems struggling to keep up with payments to the swelling ranks of retirees.

Lower and Lower - Ten-year interest rates each quarter for Canada, Germany, Japan, U.K. and U.S.

Source: Bloomberg

The Background

Nations’ normal interest rates have historically tracked economic growth, which in turn is largely determined by productivity. In the U.S., the main index of productivity rose by almost 2 percent a year in the 50 years leading up to 1970; it’s grown by less than 1 percent a year since then. Many other countries have seen a similar slowdown. A narrowing gap between rich and poor countries (crimping opportunities for “catch-up” growth), smaller increases in the number of people getting a secondary education and fewer transformational inventions like air conditioning or computers add to the problem. Meanwhile, the increasing concentration of wealth within countries and the rising global ratio of workers to dependents (thanks to declining birth rates) have been pushing up savings. Rich people are big savers, and workers save more than dependents. At the same time, the falling price of machines and other capital goods has kept spending on investment low. The surplus of savings has acted to further lower interest rates.

The Argument

If productivity growth recovers — which is possible — downward pressure on the neutral interest rate will ease. Some economists, like Erik Brynjolfsson and Andrew McAfee, argue that the full benefits of technologies such as artificial intelligence haven’t yet appeared. Others, like Tyler Cowen, insist that persistently slow growth, also called secular stagnation, is the new normal. Whatever the underlying cause, the savings surplus has complicated economic policy. Unable to cut interest rates further, central banks have had to find other ways of stimulating demand, such as quantitative easing and forward guidance (giving a clear direction to the markets, for instance by promising to keep interest rates low for longer than investors expected). More radical steps have been talked about, including so-called helicopter money and deeply negative interest rates. Fiscal policy is another possibility. Bigger budget deficits would reduce the surplus of savings and start to push inflation higher as economies get back to full employment, and that would tend to raise interest rates. Many central banks have been calling for fiscal stimulus to help them out. Trump’s election may give them more help than they bargained for.

The Reference Shelf

  • This Bank of England paper on falling global interest rates serves as an excellent guide to other sources.
  • John Williams of the San Francisco Federal Reserve discusses monetary policy in the era of very low interest rates. In a more recent note, he asks whether a higher inflation target would help.
  • In his 2016 book, “The Curse of Cash,” Harvard University professor Kenneth S. Rogoff explains how abolishing paper money would make it possible to push interest rates as negative as necessary.
  • Former U.S. Treasury Secretary Lawrence Summers and J. Bradford DeLong, professor at the University of California, Berkley, wrote on the role that fiscal policy ought to play.
  • Robert J. Gordon, professor at Northwestern University, has written the book on the growth slowdown. Summers lays out the case for secular stagnation, and Ben Bernanke, the former U.S. Federal Reserve chairman, pushes back. A QuickTake on the subject.

    First published Sept. 20, 2016

    To contact the writer of this QuickTake:
    Clive Crook in Washington at

    To contact the editor responsible for this QuickTake:
    Anne Cronin at

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