IMF Survey : Interest Rates to Increase But Modestly as Global Economy Normalizes

IMF News, April 3, 2014

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Real interest rates are expected to increase modestly with the normalization of global economic conditions, reversing the decline into negative numbers after the financial crisis.
Real interest rates now close to zero; set to rise only moderately.
Continued low real interest rates will ease the burden of debt for borrowers but can constrain policymakers and increase the chance that nominal policy rates hit the zero lower bound.
The effects of the global financial crisis on investment and output gaps are likely to persist over the next 5 years.

Saving: emerging market economies’ saving rate increased significantly between 2000 and 2007, driving down interest rates. This increase is expected to be only partly reversed.
Portfolios: since the financial crisis, demand for safe assets has increased—bonds over the increasingly risky stocks and other equity—driven also by reserve accumulation in emerging market economies. Unless there is a major unexpected change in policy, this trend is likely to continue.
Investment: the decline in investment rates in advanced economies as a result of the global financial crisis is likely to persist and contributed significantly to the decline in interest rates.
Saving glut and investors’ preferences:
- A glut of saving stemming from emerging market economies, especially China.
- A shift in investors’ preferences toward fixed income assets—such as bonds—rather than equity.
Quantified contributions:
- The substantial increase in saving in emerging market economies in the mid-2000s was responsible for more than half of the decline in real rates.
- More than half of the reduction in real rates in the first decade of the 21st century can be attributed to an increase in the relative demand for bonds.

Ten-year real interest rates across countries fell from an average of 5½ percent in the 1980s to 3½ percent in the 1990s, 2 percent over 2001–08, and 0.33 percent between 2008 and 2012.
With increased global economic and financial integration over the past three decades, real rates are largely determined by common global factors, especially at longer maturities.
While monetary policy dominated the evolution of real rates in the 1980s and early 1990s, improved fiscal policy in advanced economies was the main factor underlying the decline in real interest rates during the rest of the 1990s. More recently, saving, portfolio shifts, and investment declines have played crucial roles.

Any increase in current real interest rates is expected to be modest because the main contributing factors are unlikely to be reversed.
Part of the reason for the moderate expected increase is cyclical: extremely low recent real rates reflect a large shortfall between actual and potential output in advanced economies.
The study suggests that real rates and the cost of capital are likely to remain relatively low even when output gaps disappear.
If real interest rates are lower than real GDP growth rates, increasing public investment may not lead to increases in public debt-to-GDP ratio in the medium term because higher growth would be financing the burden of the extra debt.
A period of continued low real interest rates could mean that the neutral policy rate will be lower than it was in the 1990s or the early 2000s and could increase the probability that the nominal interest rate will hit the zero lower bound in the event of adverse shocks to demand with inflation targets of around 2 percent.

Monetary policy: lower neutral policy rates and greater risk of hitting the zero lower bound have implications for the design and implementation of monetary policy.
Fiscal policy: with real rates below real GDP growth rates, public investment may be fiscally sustainable and supportive of growth without raising debt-to-GDP ratios in the medium term.
Financial stability: continued low real (and nominal) interest rates may induce financial institutions to search for higher yields by taking on more risk, increasing systemic financial sector risks.
Recommendation: appropriate macro- and micro-prudential oversight will be critical for maintaining financial stability.

Source: IMF Survey, Andrea Pescatori and Davide Furceri, April 3, 2014.