After seven years at zero, interest rates will begin the return to normal in 2015. The surprise will be how low normal turns out to be in this economic cycle. The federal-funds rate will not go above 3%, the lowest peak of any Federal Reserve tightening spell since the early 1950s. Bond yields will not go much higher.
To understand why rates will remain low, it helps to understand what drove them down in the first place. The immediate cause was the Fed’s determination to learn the lessons of the 1930s, and of Japan’s experience in the 1990s, and inject as much monetary stimulus into the economy as it could. It slashed the federal-funds rate to zero in 2008 and then bought trillions of dollars of government bonds with newly created money (“quantitative easing”) to pull down bond yields.
Powerful headwinds still kept the recovery anaemic. By 2015, however, those headwinds will have largely dissipated. Households, after several years of “deleveraging” (paying down their pre-crisis debts), are borrowing again. Flush with capital, banks are happy to do their part: by late 2014 their loans were growing at their fastest rate since 2008 and there is talk of bubbles in student and car loans. Europe’s sovereign-debt crisis has subsided, for now. No new federal austerity is on the cards, and state and local governments are hiring again. Average monthly jobs growth gently accelerated from 186,000 in 2012 to 194,000 in 2013 to 225,000 in the first nine months of 2014. By late 2015 the unemployment rate will drop below 5.5%, the level widely considered consistent with full employment.
The new normal
Such an economy no longer needs abnormally low interest rates. But nor can it tolerate rates once considered normal. Some of the forces at work in America in the 1930s and Japan in the 1990s are present today, exercising an outsize influence on interest rates.
Historically the Fed tightened, and bond yields rose, most often because inflation threatened to erupt. But in recent decades inflation has been much more stable and lately it has been too low more often than too high. For 95% of the past six years it has been below the Fed’s 2% target, when measured by its preferred benchmark, the price index of personal consumption excluding food and energy. In late 2014 it was still only 1.5%. This will restrain the tempo and magnitude of rate rises.
Furthermore, the world has a glut of savings and a dearth of investment, and it is the job of interest rates to bring the two into balance. Before the crisis the oversupply of savings could be traced to emerging markets, in particular China. Domestic savings in emerging markets rose from 24% of GDP in the 1990s to above 33% by 2008—and stayed there. That is more than enough to meet the (steep) investment needs of those countries, so they ploughed the excess into rich-country bond markets, pushing down interest rates. China’s current-account surplus has since shrunk, but the euro zone, bludgeoned by austerity, tight credit and weak investment in Germany, has taken its place: its current-account surplus in 2015 will exceed China’s. The global savings glut will put a lid on interest rates.
The dearth of investment is more of a puzzle. Profit margins are near all-time highs and borrowing costs near all-time lows, yet capital spending has been subdued. This may be because business has become less capital-intensive. For example, startup companies can rent all the computing capacity they need in the cloud without having to buy big servers.
More important, over time long-term interest rates are highly correlated to long-term growth (see chart), and growth looks likely to be much lower in the coming decade than in the recent past. Faster-growing economies generate higher returns on capital, which encourage companies to borrow. Higher productivity growth usually translates into higher wages and encourages consumers to borrow against their future income. A slower-growing economy needs fewer stores, factories and offices, depresses the return on capital and thus leads to lower investment. Slower-growing productivity holds back incomes and discourages consumer borrowing.
Productivity growth has slowed since the recession, and the working-age population will expand by just 0.4% a year in coming decades, less than half the rate of the past two. Long-term growth, which averaged 3.2% between 1993 and 2007, may average 2% or less in the coming decade. For all these reasons, the end of the Fed’s monetary morphine will not spell the end of low interest rates.
Greg Ip: United States economics editor, The Economist