Interest Rates to Increase But Modestly as Global Economy Normalizes

Real interest rates now close to zero; set to rise only moderately

Factors influencing rates in past unlikely to reverse

Continued low rates mean cheaper debt but also constrain policy

Continued low real interest rates—the rate paid by borrowers minus the expected rate of inflation—will ease the burden of debt for borrowers but can also tie the hands of policymakers. A low real interest rate environment also enhances the chances that in the future the nominal policy rate may hit the lower bound (that is, zero), thereby losing a key monetary policy tool: lowering interest rates to stimulate growth. Because there is a risk that advanced economies will encounter continued very low growth, this limitation may materialize.

Any increase in current real interest rates is expected to be modest because the main factors contributing to the decline in real rates are unlikely to be reversed:

• 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. This was also driven 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.

Since the early 1980s, interest rates, or yields, on assets of all maturities have declined worldwide, well beyond the decline in inflation expectations. This means that real interest rates—the rates paid by borrowers corrected for expected inflation—have declined. 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 (Chart 1).

With increased global economic and financial integration over the past three decades, real rates are now 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, however, the factors mentioned above have played a crucial role.

In our study we...