Interest Rates: Low for the Long Run?

Interest rates, at least in the developed market economies, remain at or near their lowest levels in history, and the debate over when they will begin to rise is an interesting one. On the one hand, barring the introduction of some further financial chicanery by the world’s central banks (negative deposit rates anyone?) they can’t really go any lower. On the other hand, the fact that they can’t go (much) lower doesn’t mean that they necessarily have to go higher (at least, not for a long time). In the words of bond guru Bill Gross in a recent (October) investment outlook:


“If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time.  Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by 2016. Bet against that.”


This might seem a strange prediction to many. There is a school of thought that there is some ‘natural’ level of interest rates out there (probably somewhere around 5%) to which the bank rate must eventually return. After all, rational savers do demand some kind of return on their money. According to this perspective, we are probably now overdue a correction higher, as interest rates in most major economies have been well below the 5% level for the past five years. 


There is, however, a problem with this view. Interest rates will only move higher if and when the central bank wants them to. As John Maynard Keynes once wrote:


“The monetary authorities can have any interest rate they like…They can make both the short and long-term (rate) whatever they like, or rather whatever they feel to be right…Historically the authorities have always determined the rate at their own sweet will.”


And the monetary authorities like the rates just where they are, thank you very much. A recent study by McKinsey calculated that governments in the US, the UK and the EU have benefited enormously from the low level of interest rates (chart I). In fact, the British government has ‘saved’ the equivalent of 7% of the UK’s entire GDP due to a combination of absurdly low interest rates on the national debt and the profit generated by the Bank of England by bidding up the gilt prices (as it reduced government yields). Likewise, the US government has benefited to the tune of 6.7% of GDP, while Eurozone has lagged slightly (due to its less ambitious monetary policy), but still saved the equivalent of 3.8% of GDP.  


Chart I.


So, if governments (and central banks) are clearly benefiting from very low interest rates, it seems logical to conclude that interest rates will not rise in a hurry, unless something forces governments to act. Some might argue that this is entirely possible – despite the supposed austerity implemented in many countries following the financial crisis, government are continuing to spend more than they collect. In other words, they still need to borrow. As such, is it not possible that international investors, growing increasing sceptical of the risks associated with money-printing central banks, begin to demand higher and higher premiums to lend to our highly indebted governments?  Could this not lead to higher interest rates?


Well, it could (and, arguably, it should), but in our view, this scenario remains unlikely for the foreseeable future.  In a fiat money system, the central bank can always replace external demand (i.e. international investors) for its debt with its own ‘demand’. For example, if the demand begins to fall for US treasury securities, causing interest rates to rise, the Fed can just print more money, and buy the securities itself, thereby removing the upward pressure on rates. This is already the case in both the US and the UK, where the central banks now own over a third of all government bonds.    


Another way to look at this issue is that an interest rate effectively represents the price of money. In a fiat system, the monetary authority controls the supply of money – therefore it controls the interest rate.  In our view, market expectations for high interest rates, especially in countries like the UK and Canada, where markets are pricing in a non-negligible probability of 2%+ rates in 2015 (circa 15% probability in the UK, 20% in Canada) are overdone, and like Mr Gross, we expect rates to remains lower for longer than people think.  If this sounds crazy, then just look at Japan; the Land of the Rising Sun has also been the land of the frozen yield curve (with rates of about 0%) for the past two decades. 


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