Glancing at a historical chart of worldwide interest rates, it is immediately clear that central banks have cut interest rates at an unprecedented pace, especially post the financial crisis in 2008. This has been done on the premise that economic and demographic factors are forcing central bankers to move in this direction.
Average interest rates in developed markets have been in steady decline over the past 30 years. This seemingly secular trend has inspired a plethora of theories about what drives it, from trade flows and productivity, to life expectancy and demographic shifts. Depending on your choice of timeframe, you can indeed see such factors moving with interest rates in the past few decades, however it does not necessarily mean that the relationship is causal.
Over the longer term, movements in interest rates are connected to changes in monetary regimes, such as a shift from the gold standard, or toward inflation targeting. That suggests that central banks play the single-most important role in our current interest rate environment. Moreover, it is clear that central bankers have political incentives to cut rates and keep them low. In economic downturns or market crashes, rate reductions can quickly save the day. In normal times, rate increases risk bringing about the next crisis. Few central bankers want to be blamed for contributing to a recession.
This therefore begs the question, why did central bankers hold off from forcefully suppressing interest rates until the past 30 years or so? One of the main reasons is that up to the last century, central banks had to adjust rates according to the rules of the international gold standard. Central bankers faced similar constraints during most of the Bretton Woods era after World War 2, which created a collective currency regime based on the US dollar and gold.
The only period similar to today was the early years of Bretton Woods post-war system. Against the formal rules of the agreement, several countries maintained capital controls until the mid-1950s. This allowed central banks to keep rates low despite fairly high inflation. It may be surprising for some to know that during this period, several central banks held real rates negative for an extended length of time. This so-called financial repression was an effective way for governments to finance and repay their huge war debts.
Outside of this period and our current environment, real interest rates were not negative for extended stretches in the previous century. When the Bretton Woods agreement broke down in the 1970s, the world saw a gradual adoption of floating exchange rates, after which inflation-targeting took hold, pioneered by New Zealand in 1990. For the first time in a long while, central banks had free rein to cut rates as long as they could claim to be adhering to their mandates. No exchange rate-targeting or gold standard rules were holding them back.
While the previous round of negative real interest rates was used to repay war debts, this time around governments are mainly using low rates to argue for more borrowing with the intention to stimulate economic growth. The US, for one, has seen rate cuts with each crisis since the stock market crash of October 1987. Between crises, rates have been raised a little, before being slashed again to new lows. This pattern appears to follow a political imperative of avoiding market downturns and recessions.
Therefore, the implication for modern times is that ultra-low interest rates are set to remain with us for the near future. This is especially true given economists’ moderate outlook for worldwide economic growth over the next decade, creating the right constraints for central bankers to argue for an aggressive expansionary monetary policy stance.
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