The End of Zero Interest Rates

What a difference two years make. In 2021, when interest rates were near zero in the United States and the United Kingdom and slightly negative in the eurozone and Japan, the consensus was that they would remain low indefinitely. Astonishingly, as recently as January 2022, investors put the probability of rates in the US, eurozone, and the UK rising above 4% within five years at only 12%, 4%, and 7%, respectively. After adjusting for expected inflation, real interest rates were negative and projected to stay that way.

In fact, despite the US Federal Reserve and other central banks’ aggressive monetary tightening, real interest rates remained significantly negative until late 2022. Moreover, long-term rates increased more moderately than short-term rates: by October 2022, the yield curve had inverted, signaling that financial markets were expecting central banks to reduce short-term rates in the near future. This sentiment stemmed from the widespread expectation that both the US and global economies would enter recession.

The Fed recently raised its policy rate to 5.25%. In the US and many other countries, real interest rates have also moved into positive territory. And now that the US appears to have avoided a recession after all, rates will likely stay well above zero for a while.

In 2021, some monetary economists believed that the “neutral” real interest rate had fallen below zero. This shift was widely viewed as a long-term phenomenon, with the exception of occasional cyclical fluctuations, such as interest-rate spikes during periods of unusually expansionary fiscal policy. Given the Fed’s 2% inflation target, the zero real interest rate seemed to imply that the equilibrium nominal interest rate should fall to below 2%, on average. But US nominal interest rates cannot fall into negative territory, owing to the so-called zero lower bound.

In Europe and Japan, nominal interest rates did fall slightly below zero, as low as -0.5%. This was the effective lower bound. If the equilibrium real interest rate was negative and the effective lower bound on nominal rates was close to zero, the global economy would be in serious trouble. Under such conditions, monetary policy would often be too tight to achieve the economy’s equilibrium rate of growth in GDP. The responsibility for maintaining full employment would thus have to revert to fiscal policy, which is often politically fraught. This scenario is the “secular stagnation” hypothesis, popularized by former US Treasury Secretary Lawrence H. Summers in 2013.

When it comes to fiscal policy, one silver lining of chronically low real interest rates is that they make elevated levels of public debt more sustainable. Governments could operate with primary budget deficits (which exclude interest payments) and still manage their debt, as it would decrease relative to GDP over time. With interest rates having risen, however, the US debt is suddenly a problem again. The debt-to-GDP ratio is expected to resume its upward path from here on out. This was one of the reasons that Fitch Ratings downgraded US debt from its longstanding AAA credit rating on August 1. The global rise in real interest rates has also worsened debt problems elsewhere, especially in developing countries.

In 2021, both investors and economists could be forgiven for believing that equilibrium interest rates had settled close to zero for the foreseeable future. After all, short-term rates in the US had been near-zero for nine of the previous 13 years, from 2009 to 2015 and again from 2020-21. Similarly, interest rates in the eurozone had been at or at or below 1% since 2009 and dropped below zero in 2015. In Japan, interest rates have remained under 0.5% since 1996. Such prolonged periods of low interest rates had not been observed since the Great Depression.

Major countries’ nominal and real interest rates had been trending downward since at least 1992. Moreover, comprehensive analyses spanning seven centuries of data on long-term real interest rates have identified a gradual but persistent decline since the Renaissance, at about 1.2 percentage points per century.

Possible explanations for the decline in real interest rates include slowed productivity growth, demographic shifts, growing global demand for safe and liquid assets, rising inequality, lower capital-goods prices, and a savings glut coming from East Asia. Other factors, such as longer lifespans and reduced transaction costs, could help explain why real rates have been declining for centuries.

To be sure, prominent economists did not dismiss the potential for future interest-rate increases. But while they acknowledged the possibility of periodic rate spikes, many viewed such increases as unlikely in the short term and transitory in the long run. In 2018, Summers argued that the US is “likely to have, by historical standards, very low rates for a very large fraction of time going forward, even in good economic times.” In 2020, jointly with Jason Furman, Summers reiterated that “real interest rates are expected to remain negative.” As recently as June 2022, former IMF Chief Economist Olivier Blanchard observed that “the long decline in safe interest rates stems from deep underlying factors that do not appear likely to reverse anytime soon.”

Short-term nominal interest rates are now above 5%, and real interest rates have returned to positive territory. While some monetary economists still expect interest rates to revert to zero, they may have been overly influenced by the dramatic shifts of 2008-21. After all, the prospect of equilibrium interest rates reaching zero or negative territory was almost unthinkable before the 2008 global financial crisis (at least outside of Japan).

While I cannot predict the future, I am skeptical that interest rates will return to zero anytime soon. If this assessment is correct, it bodes well for monetary policy, which would be less constrained than previously. But high real interest rates are bad news for fiscal policymakers, who could find themselves once again constrained by unsustainable debt-to-GDP ratios.