Podcast: Macro Waves
Negative nominal interest rates: causes 10/28/2019

In the first part of this podcast, William De Vijlder analyses the causes of negative rates while explaining how they can brought about the “paradox of thrift”. What does this concept cover? And how could negative rates foster the emergence of such a paradox?

TRANSCRIPT // Negative nominal interest rates: causes : October 2019

Part 1 - Negative nominal interest rates: causes

Before starting to discuss the causes of negative interest rates, we should explain what the paradox is about.

The paradox of thrift or of saving has been made popular by John Maynard Keynes, although it goes back far in time. It means that when people decide to increase their savings, which may make sense at the individual household level, it has a negative impact in the aggregate because it slows down consumption and hence economic growth.

Why devote a podcast on this topic and why now?

The topic is important: if the paradox exists, monetary policy will fail to stimulate growth and inflation. This is a problem, not only for the central bank but for all of us.

Why for all of us?

If growth slows, that mean income growth will slow and job creation will slow as well. Moreover, the ECB might decide it has no other option than to become even more aggressive in its monetary policy, meaning even lower rates than today.

Why discuss the paradox now?

With rates being very low and often negative, it increases, at least theoretically, the risk of becoming confronted with this paradox.

So savings’ behaviour is the thing to monitor. How do economists actually calculate savings and the savings rate?

Saving is the part of the gross disposable income which is not spent as final consumption expenditure.

The household savings rate is defined as gross household saving divided by gross disposable income, therefore, the savings rate increases when gross disposable income grows at a higher rate than final consumption expenditure.

Saving rates can be measured on either a gross or net basis. Net savings rates are measured after deducting consumption from fixed capital (depreciation of dwellings).

Household savings can be used for household capital formation (essentially the purchase and renovation of dwellings) and for financial savings.

Moving to interest rates now. Why are some of them negative?

There are various reasons and the explanatory factors may differ depending on whether we look at short term or long term interest rates.

So long term rates can be negative as well?

Oh yes. Some time ago, Germany issued a 30 years bond with a negative coupon, although there was little investor enthusiasm.

In explaining the causes of negative interest rates, it is useful to look at the neutral interest rate. The real neutral (or natural) rate of interest is the rate at which GDP is at its potential and hence inflation is stable provided there are no shocks to demand (which would hit realised GDP) and supply (which would hit potential GDP).

To put it differently, it’s the interest rate at which the economy is in equilibrium.

"Conceptually one of the most important variables in modern macroeconomics, r* is the real rate of interest that brings output into line with its potential or natural level in the absence of transitory shocks (in the case of semi-structural models) or nominal adjustment frictions (in the case of DSGE models). r* thus closes the output gap and stabilises inflation, either eventually or concomitantly depending on the type of model. Numerous factors, such as demographics or technological progress in the long run, or changes in risk aversion in the short run, affect r*". (ECB)

Why is this neutral rate the logical starting point?

First, it reminds us that the neutral rate can rise or decline for structural reasons, which have little or nothing to do with monetary policy. This is an important point. It means that a central bank is not the only cause and perhaps not even the major reason why the rates are low.

Second, the neutral rate anchors the official rate of interest set by the central bank: the policy rate will be set having in mind the neutral rate. This anchoring should not be interpreted in a strict sense: estimating the neutral rate of interest in real time is fraught with issues, a bit like real-time estimates of the output. Hence the neutral rate is more a reference, with a confidence band around it, rather than a precise estimate.

If the official rate is higher than the neutral rate, policy is not in an accommodating stance, even though the policy rate can be low.

"Central banks can influence the short-term real interest rate relative to its equilibrium value by changing the short-term nominal interest rates, thereby influencing the real economy and inflation developments. If the key interest rate less the expected inflation rate is below the natural interest rate, it may be expected that households will use the opportunity of loans at relatively favourable rates to expand consumption; enterprises thereupon invest more, produce above potential in the goods market and raise their prices, which leads to an increase in the rate of inflation. If, on the other hand, the key interest rate less expected inflation is higher than the natural interest rate, capacity underutilisation and falling inflation would be expected." (Bundesbank)

Where is the neutral rate now?

One assume that it is around 0% in the eurozone.

These are very low numbers. How come?

As mentioned before it’s a combination of various factors:

"Our estimates show a declining trend in r* in the advanced economies starting in the 1980s, driven by lower trend growth and demographic factors. Risk aversion and flight to safety are shown to have contributed to a further decline in the wake of the global financial crisis."(ECB)

But monetary policy also played a role?

Indeed. Traditional interest rate policy, QE and forward guidance have contributed to a decline in long-term bond yields, either by lowering expectations for the policy rate or by ‘duration extraction’. This drives down the term premium, i.e. the premium for taking duration risk.

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