Why are interest rates so low?

Never in recent economic history have interest rates been so low for such a long period of time in most advanced economies.

In the United States, the euro zone, Japan and the United Kingdom, the short-term intervention rates of central banks are today essentially zero, while yields on long-term government bonds have plumbed new depths – at less than 0.2% for Germany’s 10-year Treasury bond – and yields on a range of short-to medium-term debt have turned negative (including in France). Investors are now paying for the privilege of lending to seemingly safe governments for periods of five years or so. This extraordinary situation naturally begs the question “why”?

A first explanation is low inflation expectations. Part of long-term interest rates reflects an inflation premium, which compensates the investor for the potential loss in the purchasing power of money over the term of the security. In recent decades, the inflation premium has gradually come down to very low levels, reflecting a decline in inflation expectations attributable in part to the success of central banks’ commitment to low and stable inflation. But the real (or inflation-adjusted) interest rates have also come down to very low levels, which can be indicative of a downgrading of longer-term growth prospects, caused, for instance, by ageing and declining labor-supply growth in most advanced countries. The “secular stagnation” hypothesis is the claim that the global economy is suffering from chronically deficient demand, pushing the equilibrium real interest rate – the interest rate consistent with full employment of labor and capital resources – into negative territory. 

Another possible explanation for today’s unusually low interest rates is a scarcity of “safe” assets. This could result from central banks’ large-scale purchases of government bonds - a process known as quantitative easing, or QE. In an effort to reinvigorate growth in the wake of the global financial crisis, main central banks have lowered short-term rates to virtually zero, even lower than zero in the euro zone, before exerting direct downward pressure on long-term rates trough QE. But the scarcity of bonds could also be due to elevated risk aversion, leading to a portfolio shift by investors toward government bonds, perceived as more valuable as a hedge against risks than other assets. New regulations intended to foster financial stability have also constrained banks, pension funds and insurance companies to hold more government debt. In the face of declining net issuance, a big shift in the demand for government bonds can cause Treasury yields to fall to zero. Once the interest rate hits zero, there is nothing, mathematically speaking, which prevents the interest rate to go negative if demand for bonds continues to exceed supply.