Is there still room for interest rates to rise?

In the eurozone, money market rates have been holding in negative territory for more than four years. The highest-rated government and corporate bonds are still yielding less than 1%.

The distribution of interest rates around the zero lower bound was initially seen as an exceptional crisis adjustment mechanism, but the situation persists.

Some expect this exceptional period to finally come to a close once the European Central Bank halts its net securities purchases and possibly begins to raise key rates after summer 2019.

For others, the situation has definitively changed: a bit like Japan, the diminution of eurozone interest rates marks the erosion of growth potential and the quasi-elimination of inflation.

In this article, we take a median stance between these two positions: the eurozone is not exactly Japan, and prevailing interest rates will not hold indefinitely at the zero lower bound.

Yet the eurozone is not an optimum monetary zone, one in which transfers balance out the effects of interest rate increases varying from one country to the next. Regardless of the timeframe, key rate increases are bound to be gradual and limited in scope.

The ECB sees this as a sign that prices will pick up and that it can begin to normalise monetary policy. On 1 January 2019, it halted its net securities purchases. Thereafter – by next fall at the earliest – it should be able to raise its key rates.

The concomitant upturn in inflation and interest rates is also one of the assumptions underlying the forwards curve (see right side of chart 1). By the end of 2021, they point to roughly a half-point increase in money market rates, which would swing back into positive territory[1]. The yield on 10-year German government bonds, the benchmark rate for long-term loans, is supposed to rise from 0.10% to 1.15%.

In the end, however, which mechanism is most likely to drive up prices? Wage pressures are a necessary condition, but they won’t suffice since they can be totally or partially absorbed by corporate margins. This is currently the case in the eurozone, where a cooler business climate does not argue in favour of boosting corporate pricing power. Since summer 2018, the ratio between the GDP deflator and unit labour costs has declined, indicating that corporate profits are eroding. This trend is especially strong in Germany, where wage growth is continuing at a dynamic pace (3% slope), but mediocre business prospects are straining price formation (chart 2).

In the short term, the cyclical environment is hardly propitious for an upturn in inflation or interest rates. Once again, the ECB and the markets seem to have overly optimistic expectations. The future hasn’t been written yet, and it seems worthwhile to take a look at long-term trends.

Following in Japan’s footsteps?

The Japanese economy provides a textbook case of a wealthy but aging population, one that complies very closely with the steady state depicted in certain growth models (see box, page 3). In Japan, per capita capital stock is among the highest in the world: productivity gains, potential growth and inflation are all converging on zero, which has also become the norm for interest rates for the past decade (see chart 3).

What rates for tomorrow?

In keeping with theory, for many long years the economic growth rate has served as the benchmark for interest rates. From 1998 to 2008, 5-7 year bond yields fluctuated around 4% in the eurozone, which is the same pace as nominal GDP. Thereafter, nominal GDP declined due to the financial and sovereign debt crises as well as to the demographic transition described above. It is now closer to 2.5%. Using conservative assumptions for term premiums, this would place the ECB’s target rate at somewhere between 1.75% and 2%.

Yet returning to these levels will be no easy task. With the swelling of yield spreads and divergent growth rates within the eurozone (see chart 4), now more than ever it is clear that higher interest rates will not have the same impact across the board. Germany will adapt easily since it has little debt and will continue to borrow at the lower end of the yield spread. Italy, in contrast, will face a much tougher situation, since growth has stagnated and public debt has swelled by 30 points of GDP since 2008, unless we make exaggerated assumptions about its spread.

In a monetary zone that is not optimal, the notion of a neutral interest rate is not as pertinent. A 2% target based on average economic growth trends proves to be too restrictive for some, but not restrictive enough for others. To cover for the absence of transfers and to address the sovereign debt crisis, the ECB opted for a resolutely accommodative monetary policy. Without any institutional advances, this position is unlikely to change quickly. The next upward phase of the interest rate cycle is bound to be gradual and limited in scope, and 2% seems more like a ceiling than the norm.

[1] The 3-month Euribor rate is projected at 0.20% in December 2021, vs a spot rate of 0.30% at 20/02/2019.

[2] According to the OECD, in Q3 2018, the employment rate in the 15-64 age group was 67.4% in the eurozone and 77.3% in Japan.