Interest rates: In search of a “new normal”

Interest rates: In search of a “new normal”

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Speaker(s): Rolf Ketzler (German Insurance Association)

Real and nominal interest rates in most advanced economies have been on a strong downward trend over the past three decades. A number of structural factors like population ageing, higher global savings or slower productivity growth have all been used to explain this phenomenon. The downward trend accelerated in the aftermath of the financial crisis, leading even to negative rates in a number of government bond markets. Concerns have been expressed that the prolonged period of low interest rates does not represent a deviation from a higher norm but rather a new lower equilibrium ("low for long"). By linking their monetary policy decisions to the fall in the "natural" rate as was done for example by the ECB in recent years, central banks seem to share the latter interpretation. This raised attention to the question to what extent the natural interest rate, which defines a state of the economy with stable prices and GDP growth in line with potential, has fallen.

The recent increase in long-term interest rates in line with the pick-up of economic growth since the end of 2016 sheds some first doubt on the "new equilibrium" view. Likewise, the large-scale asset purchase program by the ECB has resulted in a reduction of (long-term) interest rates below their "natural" value - but this program cannot last forever. The gradual normalization of monetary policy in the euro area, which is likely to start in early 2018, is likely to push bond yields higher over the coming months. While it is very unlikely that real long term interest rates will return to prior long-term norms, we present our assessment based on structural factors mentioned above how the (natural) long term interest rate will develop once monetary policy will have adopted a more normal stance.

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