Charts of the week: the end of interest rates?

This week, our charts of the week focus on the extra-ordinary decline in real interest rates in developed economies. Real interest rates have been falling for nearly 30 years. This year, most of the decline in nominal interest rates is due to a further fall in the level of real interest rates. Real interest rates are now at remarkably low levels and priced to stay low for a long time. This situation naturally begs the question “why?” In speeches and recent publications, members of the Bank of England’s Monetary Policy Committee have discussed this phenomenon. The commentary below has been gleaned from their deliberations to provide an overview of what this extraordinary development may mean about the current and future state of the global economy. • Exhibit 1: The decline in real interest rates in developed economies is nothing new – they’ve been falling for the last thirty years:

Exhibit 1: Global real interest rates 1970 - 2014.

The graph below shows and ex post measure of the long-run global real interest rate, estimated as the difference between 10-year nominal government bond yields and current annual CPI inflation outturns for the G7 countries (Canada, France, Germany, Italy, Japan, UK and US), weighted together using PPP weights. The graph was produced by the Bank of England using IMF and BoE calculations.

Source: Bank of England, October 2014.

• The decline in interest rates affects both spot government bond yields (interest rates over the next few years) and forward interest rates (i.e. the implicit cost of borrowing for five years in five years’ time) • The extent of the fall in real interest rates this year is very striking: five-year real interest rates expected in five years’ time have fallen by over 100 basis points in the eurozone, the UK and the US (see exhibit 2 below) Exhibit 2: Longer-term interest rates have fallen internationally during 2014

Five-year, five-year forward nominal interest rates (a)

Source: Bank of England, Inflation Report, November 2014.

• Nominal long-term interest rates can be broken down into movements in real interest rates and implied inflation. Exhibit 3 shows that most of the fall in long-term interest rates in 2014 can be accounted for by lower real interest rates. This is the case in the eurozone, the US and the UK

Exhibit 3: Most of the fall in nominal forward rates can be accounted for by lower forward real rates.

Contribution to the decline in five-year, five-year forward nominal interest rates since the start of 2014

Exhibit 3 shows changes between 31/12/13 and the fifteen working days to 5/11/14. The data is produced by the Bank of England using government liability curves. The contribution of real rates and implied inflation expectations to the change in nominal rates has been calculated by the BoE using inflation swap rates.

Source: Bank of England, Inflation Report, November 2014.

• In October, interest rates for government borrowing over all horizons reached all-time lows. UK real interest rates are now expected to remain negative for at least the next 40 years. The pattern is less dramatic in the US and the eurozone, but even in these regions real interest rates remain at exceptionally low levels over all horizons

Exhibit 4: Forward real interest rate yield curves

Notes: Data for the UK and US are derived by the BoE using five-year, five year forward nominal bond yields deflated using inflation swaps. The Germany/euro area figures show the five-year, five year forward nominal Bund yield deflated using euro area inflation swaps (as a proxy for the euro area risk free rate). Inflation measure used is RPI for the UK and CPI for the US and euro area.

Source: Bank of England, Speech by Andrew G Haldane, Chief Economist, Bank of England. Data as of 15/10/14.

• One explanation for the secular downward trend in real interest rates is that it simply reflects a portfolio shift by investors toward government assets – a sort of globalised ‘flight to quality’ in a world of heightened geopolitical risks. If this were the case then the implications for growth would be fairly benign and would not cast doubt on hopes for a business-as-usual economic recovery • Alternatively, the fall in real interest rates may be indicative of a downgrading of future growth prospects, which would require lower-for-much-longer policy rates. This interpretation of events would be more in line with the secular stagnation hypothesis (click here to read more about secular stagnation) • Recent comments made by members of the BoE’s MPC suggest that they doubt the idea that secular stagnation is taking hold. They are not so pessimistic as to believe that negative real returns will be with us for the next 20 years. They do however recognise that recent developments (slower global growth, weaker inflation and heightened geopolitical risks) leave them gloomier in their assessment of the economy. Lower-for-longer is therefore the message on official rates in the UK. References for this post:

Twin peaks - Speech given by Andrew G Haldane, Chief Economist, Bank of England, 17/10/14 (click here to access the full text for this speech)
Monetary policy, asset prices and distribution - Speech given by Ben Broadbent, Deputy Governor for Monetary Policy, Bank of England, 23/10/14. (click here to access the full text for this speech)
Bank of England, Inflation Report, November 2014 (click here to access the inflation report)