Friday, November 13, 2015

Low Interest Rates: It Isn’t Just QE

We’re nearing Fed “liftoff” with a better than 50% chance that the US Fed Funds Rate will rise above 0%-0.25% for the first time since 2008. But even taking into consideration the extraordinary monetary accommodation conducted by the major advanced economy central banks, interest rates globally have been in secular decline for very nearly 50 years, since the heyday of stagflation in the 1970s.

Money printing doesn’t half explain what’s going on.

When I began my career a couple of decades ago, mortgage rates in Malaysia were typically  9%-10% per annum. Now, even after five rate hikes since 2009, bank lending rates remain near historical lows (%):

01_lending rate

Deposit rates are even lower, much to the chagrin of savers and pensioners. Some of this is blamed on central bank policy, that they have “printed” too much money by keeping reserve requirements too low (thus allowing banks to overlend), and/or printing money themselves, and/or forcing down policy rates. Others point to financial innovation, which allowed banks to securitise their loan books and engage in increased lending.

But these criticisms ignore much of how the monetary system works. Most central banks target very short term interbank rates via various instruments or monetary operations. The transmission of changes in the policy rate to longer term lending and deposit rates is generally incomplete, and steadily decreases as tenors increase i.e. the longer the term of a loan or a deposit, the less likely the interest rate charged is going to be affected by changes in policy rates.

This is true not just of Malaysia, which has a relatively developed financial sector, but also of bigger, financial deeper economies such as the United States (hence the importance of quantitative easing and qualitative easing, but those are stories for another day). The situation is even worse in emerging economies with underdeveloped financial systems. In Malaysia’s case, the impact of changes to the OPR fall to near zero beyond 5 years.

So something else is going on.

This VoxEU article takes a stab at explaining why (excerpt):

Causes and consequences of persistently low interest rates

The past two decades have witnessed an extraordinary decline in both short- and long-term interest rates in the leading advanced economies…

…It may be tempting to link this fall in yields to the actions of central banks, but this would be to confuse cause and effect….

...Because the overall global savings/investment rate has been relatively stable, it is not so easy to disentangle the relative importance of a rise in the propensity to save and a fall in the propensity to invest (the global savings/investment rate might be expected to rise if it is the former and fall if it is the latter). This relative stability of the global savings/investment rate probably reflects the low elasticity – at a global level – of savings and/or investment to changes in the real rate of interest.

Our discussion of the evidence therefore relies more on whether the timing of movements in the underlying drivers fits with the decline in rates. This leads us to conclude that demographic developments are likely to have been an important factor increasing the propensity to save, not just in China but more generally. In particular, aggregate saving should reflect the relative sizes of the population shares of the middle-aged, who are in their peak earnings years and so saving for their retirement, and those who are retired, who will instead be running down their savings. We note that the period of falling interest rates has coincided with a period when the population share of the high-saving middle-aged (40-65 years) has been rising relative to that of the population aged over 65 (and especially so in China)....

...This is unlikely to have been the only factor at work, however. The partial integration of China into global financial markets and the associated capital outflows will also have placed downward pressure on real interest rates for much of the period, though less so recently….

…While the downward trend in rates has been pretty remorseless since the late 1990s, it would be unwise simply to assume that the trend will be maintained...In particular, aggregate savings propensities should fall back as the bulge of high-saving middle-aged households moves through into retirement and starts to dissave. Indeed this process has already begun (see Figure 1). And though Chinese financial integration still has some way to run, the net flow of Chinese savings into global financial markets has already started to ebb as the pattern of Chinese growth rotates towards domestic demand rather than net exports. Finally, the shifts in portfolio preferences should, at least partially, unwind as investor confidence returns. But crucially, the time scale over which such a rebound in real interest rates will be manifest is highly uncertain and will be influenced by longer-term fiscal and structural policy choices.

Although we conclude that there are good reasons to expect real interest rates in due course to recover from their present unusually low levels, it is possible that the present environment will persist for some considerable time yet. So long as it does, there are two particular consequences that will complicate the task of central banks.

First, at least with current inflation targets of around 2%, episodes where policy rates are constrained by their lower bound are likely to become more frequent and prolonged....

...Second, and possibly more importantly, a world of persistently low interest rates may be more prone to generating a leveraged ‘reach for yield’ by investors and speculative asset-price boom-busts.

The pace at which underlying real interest rates yields recover will, however, be influenced by longer-term fiscal and structural policies. In particular, policies that encourage later retirement can lower the aggregate propensity to save, as will – for some countries – better household safety nets that reduce the need for self-insurance. By the same token, establishing and maintaining a stable and business-friendly fiscal and legal framework can encourage greater investment….

In short, it’s my fault. Or rather, it’s the fault of the Baby Boomers and Gen Xers, who form a bulge in the global population pyramid.

There’s a lot to absorb in the above, but to summarise:

  1. Falling global interest rates have coincided with an increase in the ratio of the population in the prime earning age bracket;
  2. China’s arrival on the world stage added to the underlying pressure, as a high household savings rate and lack of a safety net drove Chinese households to save and invest on a massive scale;
  3. These trends are beginning to reverse;
  4. In the meantime, we run risks of deflationary episodes and over-risky investing due to excess global savings;
  5. Raising the retirement age, developing a social safety net, and encouraging business investment will help in the reversal, by reducing the propensity to save and increasing the propensity to invest (thus addressing the savings/investment imbalance)

It might take another 40-50 years before we return to the “normal” of higher interest rates. But as the world population rebalances, there may be a time when we look back with regret and nostalgia at the low interest rate environment we’re in today.

Technical Notes:

The full paper can be downloaded here:

Sir Charles Bean, Christian Broda , Takatoshi Ito, Randall Kroszner, "Low for Long? Causes and Consequences of Persistently Low Interest Rates", 17th CEPR-ICMB Geneva Report on the World Economy, October 2015


  1. Hi Hisham,

    Coming from a streetman perspective, I wonder -- is the "interest-rates hike" fear overhyped? After all, it's just 25bps hike to 0.5%, still super low, but people are shouting like Chicken Little.


    1. @Fung

      Investors aren't looking at just the first hike. What people are worried over is the pace of Fed tightening (how fast), and what the terminal rate will be (how far). One and done is extremely rare in central bank history.

    2. Thanks Hisham. But I thought the Fed has repeatedly hinted that the rates hike will be gradual. Also, we have received a lot of comfort from the delays which implied that the Fed is indeed very "kiasu" and "kiasi" in moving the needle. In fact, I actually wanted the Fed to just fxxcking raise it (the first hike) once and for all and stop the foreplaying, it's been 7 years years since (since the time when S&P500 was at 800, US GDP growth at -4% & US unemployment at 10%).

      My opinion is purely based on layman's-common-sense judgement, nothing technical.


  2. Agree that "encouraging business investment will help in the reversal". Unlike the over-investment in the emerging markets (especially in the commodity-production segment) to support China's growth, the U.S. companies' spending on capex and M&A are relatively slow. S&P 500 companies have been just sitting on the cash with low interest rates, or at best buying back shares at high prices. But what can the Fed do to push?


    1. @Fung

      That's not really the Fed's job, that's more a job for the government. If the private sector is not willing to invest, the government should do so (fixing roads for example).

  3. "it is not so easy to disentangle the relative importance of a rise in the propensity to save and a fall in the propensity to invest (the global savings/investment rate might be expected to rise if it is the former and fall if it is the latter)."

    Sorry i have difficulties in understanding it, did the article just said that should the MPS increase, the rate would increase? It seems to contradict your point number 1 in the summary

    Thanks Hishamh

    1. Hisham, same here, I am confused too as to what the rates are referring to. I recalled that whatever that is saved in the system will be invested somewhere else according to the theoretical identity of savings = investments, which was referred to as the savings investments gap. That is one reason why excess savings in China and Japan provided ample liquidity to the US financial system in precipitating the 08 crisis. Is the article actually implying that the rise in demographic trend in China and hence aggregate savings with subsequent integration to the global financial system contributed to the decline in real interest rates globally, through increased buying up of government bonds/securities ( investment )?

    2. @Group 8

      They're referring to the overall rate of savings and investment, not the interest rate. If people decided to save more, both the rate of savings and investment could be expected to rise (though not necessarily to the same degree). Similarly, a drop in investment would be expected to reduce the rate of (future) savings. Either one could result in the widening of S > I that we've seen over the past few decades.


      Essentially yes, though I have to point out a few things:

      1. The actual identity is S ≡ E(I) i.e. savings is equal to expected investment, not actual investment. The only way a savings/investment gap would arise is if savings ≠ actual investment;

      2. Japan is an outlier in the narrative described in the article, as by rights they should have long passed into the consumption phase (drawing down savings). China is certainly a big factor in the excess savings story, but let's not forget some of the other emerging markets as well. Most of East Asia ran current account surpluses since 2000, as did the other BRIC countries [S ≡ E(I) ≡ (X-M)];

      3. I'm leery of calling the buying of government bonds/debt securities as "investment". In asset markets, there are always two parties to a transaction; therefore every such investment also involves someone else simultaneously divesting;

      4. I think the link between demographics and national savings is more indirect than described in the article. Most national "savings" are in fact corporate, not household. This doesn't change the narrative much (lower population growth could result in less corporate investment for future productive capacity i.e. a bigger savings/investment gap), but I'm not sure if the conclusions still hold under those circumstances. Japan's apparent exceptionalism is certainly grounds for caution. Something to think about.

    3. Thanks Hisham for the explanation, it is much clearer now. I will be certain to ask more questions down the line in your blog posts, hope you don't mind.