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Visualizing the 700-Year Fall of Interest Rates

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Visualizing the 700-Year Decline of Interest Rates

eight centuries interest rates

Visualizing the 700-Year Decline of Interest Rates

How far can interest rates fall?

Currently, many sovereign rates sit in negative territory, and there is an unprecedented $10 trillion in negative-yielding debt. This new interest rate climate has many observers wondering where the bottom truly lies.

Today’s graphic from Paul Schmelzing, visiting scholar at the Bank of England (BOE), shows how global real interest rates have experienced an average annual decline of -0.0196% (-1.96 basis points) throughout the past eight centuries.

The Evidence on Falling Rates

Collecting data from across 78% of total advanced economy GDP over the time frame, Schmelzing shows that real rates* have witnessed a negative historical slope spanning back to the 1300s.

Displayed across the graph is a series of personal nominal loans made to sovereign establishments, along with their nominal loan rates. Some from the 14th century, for example, had nominal rates of 35%. By contrast, key nominal loan rates had fallen to 6% by the mid 1800s.

Centennial Averages of Real Long-Term “Safe-Asset”† Rates From 1311-2018

%1300s1400s1500s1600s1700s1800s1900s2000s
Nominal rate7.311.27.85.44.13.55.03.5
Inflation2.22.11.70.80.60.03.12.2
Real rate5.19.16.14.63.53.42.01.3

*Real rates take inflation into account, and are calculated as follows: nominal rate – inflation = real rate.
†Safe assets are issued from global financial powers

Starting in 1311, data from the report shows how average real rates moved from 5.1% in the 1300s down to an average of 2% in the 1900s.

The average real rate between 2000-2018 stands at 1.3%.

Current Theories

Why have interest rates been trending downward for so long?

Here are the three prevailing theories as to why they’re dropping:

1. Productivity Growth

Since 1970, productivity growth has slowed. A nation’s productive capacity is determined by a number of factors, including labor force participation and economic output.

If total economic output shrinks, real rates will decline too, theory suggests. Lower productivity growth leads to lower wage growth expectations.

In addition, lower productivity growth means less business investment, therefore a lower demand for capital. This in turn causes the lower interest rates.

2. Demographics

Demographics impact interest rates on a number of levels. The aging population—paired with declining fertility levels—result in higher savings rates, longer life expectancies, and lower labor force participation rates.

In the U.S., baby boomers are retiring at a pace of 10,000 people per day, and other advanced economies are also seeing comparable growth in retirees. Theory suggests that this creates downward pressure on real interest rates, as the number of people in the workforce declines.

3. Economic Growth

Dampened economic growth can also have a negative impact on future earnings, pushing down the real interest rate in the process. Since 1961, GDP growth among OECD countries has dropped from 4.3% to 3% in 2018.

Larry Summers referred to this sloping trend since the 1970s as “secular stagnation” during an International Monetary Fund conference in 2013.

Secular stagnation occurs when the economy is faced with persistently lagging economic health. One possible way to address a declining interest rate conundrum, Summers has suggested, is through expansionary government spending.

Bond Yields Declining

According to the report, another trend has coincided with falling interest rates: declining bond yields.

Since the 1300s, global nominal bonds yields have dropped from over 14% to around 2%.

bond yields declining

The graph illustrates how real interest rates and bond yields appear to slope across a similar trend line. While it may seem remarkable that interest rates keep falling, this phenomenon shows that a broader trend may be occurring—across centuries, asset classes, and fiscal regimes.

In fact, the historical record would imply that we will see ever new record lows in real rates in future business cycles in the 2020s/30s

-Paul Schmelzing

Although this may be fortunate for debt-seekers, it can create challenges for fixed income investors—who may seek alternatives strategies with higher yield potential instead.

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Central Banks

How Global Central Banks are Responding to COVID-19, in One Chart

What policy tools are global central banks implementing to combat the economic effects of COVID-19? We compare the responses of 29 countries.

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How Global Central Banks are Responding to COVID-19

When times get tough, central banks typically act as the first line of defense.

However, modern economies are incredibly complex—and calamities like the 2008 financial crisis have already pushed traditional policy tools to their limits. In response, some central banks have turned to newer, more unconventional strategies such as quantitative easing and negative interest rates to do their work.

In response to the COVID-19 pandemic, central banks are once again taking decisive action. To help us understand what’s being done, today’s infographic uses data from the International Monetary Fund (IMF) to compare the policy responses of 29 systemically important economies.

The Central Bank Toolkit

To begin, here are brief descriptions of each policy, which the IMF sorts into four categories:

1. Monetary Policies

Policies designed to control the money supply and promote stable economic growth.

Policy NameIntended Effect
Policy rate cutsStimulates economic activity by decreasing the cost of borrowing
Central bank liquidity supportProvides distressed markets with additional liquidity, often in the form of loans
Central bank swap linesAgreements between the U.S. Fed and foreign central banks to enhance the provision of U.S. dollar liquidity
Central bank asset purchase schemesUses newly-created currency to buy large quantities of financial assets, such as government bonds. This increases the money supply and decreases longer-term rates

2. External Policies

Policies designed to mitigate the effects of external economic shocks.

Policy NameIntended Effect
Foreign currency interventionStabilizes the national currency by intervening in the foreign exchange market
Capital flow measuresRestrictions, such as tariffs and volume limits, on the flow of foreign capital in and out of a country

3. Financial Policies for Banks

Policies designed to support the banking system in times of distress.

Policy NameIntended Effect
Easing of the countercyclical capital bufferA reduction in the amount of liquid assets required to protect banks against cyclical risks
Easing of systemic risk or domestic capital bufferA reduction in the amount of liquid assets required to protect banks against unforeseen risks
Use of capital buffersAllows banks to use their capital buffers to enhance relief measures
Use of liquidity buffersAllows banks to use their liquidity buffers to meet unexpected cash flow needs
Adjustments to loan loss provision requirementsThe level of provisions required to protect banks against borrower defaults are eased

4. Financial Policies for Borrowers

Policies designed to improve access to capital as well as provide relief for borrowers.

Policy NameIntended Effect
State loans or credit guaranteesEnsures businesses of all sizes have adequate access to capital
Restructuring of loan terms or moratorium on paymentsProvides borrowers with financial assistance by altering terms or deferring payments

Putting Policies Into Practice

Let’s take a closer look at how these policy tools are being applied in the real world, particularly in the context of how central banks are battling the effects of the COVID-19 pandemic.

1. Monetary Policies

So far, many central banks have enacted expansionary monetary policies to boost slowing economies throughout the pandemic.

One widely used tool has been policy rate cuts, or cuts to interest rates. The theory behind rate cuts is relatively straightforward—a central bank places downward pressure on short-term interest rates, decreasing the overall cost of borrowing. This ideally stimulates business investment and consumer spending.

If short-term rates are already near zero, reducing them further may have little to no effect. For this reason, central banks have leaned on asset purchase schemes (quantitative easing) to place downward pressure on longer-term rates. This policy has been a cornerstone of the U.S. Federal Reserve’s (Fed) COVID-19 response, in which newly-created currency is used to buy hundreds of billions of dollars of assets such as government bonds.

When the media says the Fed is “printing money”, this is what they’re actually referring to.

2. External Policies

External policies were less relied upon by the systemically important central banks covered in today’s graphic.

That’s because foreign currency interventions, central bank operations designed to influence exchange rates, are typically used by developing economies only. This is likely due to the higher exchange rate volatility experienced by these types of economies.

For example, as investors flee emerging markets, Brazil has seen its exchange rate (BRL/USD) tumble 30% this year.

In an attempt to prevent further depreciation, the Central Bank of Brazil has used its foreign currency reserves to increase the supply of USD in the open market. These measures include purchases of $8.8B in USD-denominated Brazilian government bonds.

3. Financial Policies for Banks

Central banks are often tasked with regulating the commercial banking industry, meaning they have the authority to ease restrictions during economic crises.

One option is to ease the countercyclical capital buffer. During periods of economic growth (and increased lending), banks must accumulate reserves as a safety net for when the economy eventually contracts. Easing this restriction can allow them to increase their lending capacity.

Banks need to be in a position to continue financing households and corporates experiencing temporary difficulties.

—Andrea Enria, Chair of the ECB Supervisory Board

The European Central Bank (ECB) is a large proponent of these policies. In March, it also allowed its supervised banks to make use of their liquidity buffers—liquid assets held by a bank to protect against unexpected cash flow needs.

4. Financial Policies for Borrowers

Borrowers have also received significant support. In the U.S., government-sponsored mortgage companies Fannie Mae and Freddie Mac have announced several COVID-19 relief measures:

  • Deferred payments for 12 months
  • Late fees waived
  • Suspended foreclosures and evictions for 60 days

The U.S. Fed has also created a number of facilities to support the flow of credit, including:

  • Primary Market Corporate Credit Facility: Purchasing bonds directly from highly-rated corporations to help them sustain their operations.
  • Main Street Lending: Purchasing new or expanded loans from small and mid-sized businesses. Businesses with up to 15,000 employees or up to $5B in annual revenue are eligible.
  • Municipal Liquidity Facility: Purchasing short-term debt directly from state and municipal governments. Counties with at least 500,000 residents and cities with at least 250,000 residents are eligible.

Longer-term Implications

Central bank responses to COVID-19 have been wide-reaching, to say the least. Yet, some of these policies come at the cost of burgeoning debt-levels, and critics are alarmed.

In Europe, the ECB has come under scrutiny for its asset purchases since 2015. A ruling from Germany’s highest court labeled the program illegal, claiming it disadvantages German taxpayers (Germany makes larger contributions to the ECB than other member states). This ruling is not concerned with pandemic-related asset purchases, but it does present implications for future use.

The U.S. Fed, which runs a similar program, has seen its balance sheet swell to nearly $7 trillion since the outbreak. Implications include a growing reliance on the Fed to fund government programs, and the high difficulty associated with safely reducing these holdings.

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Central Banks

The Fed’s Balance Sheet: The Other Exponential Curve

Quantitative easing has led to an unprecedented expansion of the Fed’s balance sheet, leaving some economists with more questions than answers.

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The Fed’s Balance Sheet: The Other Exponential Curve

As the threat of COVID-19 keeps millions of Americans locked down at home, businesses and financial markets are suffering.

For example, a survey of small-business owners found that 51% did not believe they could survive the pandemic for longer than three months. At the same time, the S&P 500 posted its worst first-quarter on record.

In response to this havoc, the U.S. Federal Reserve (the Fed) is taking unprecedented steps to try and stabilize the economy. This includes a return to quantitative easing (QE), a controversial policy which involves adding more money into the banking system. To help us understand the implications of these actions, today’s chart illustrates the swelling balance sheet of the Fed.

How Does Quantitative Easing Work?

Expansionary monetary policies are used by central banks to foster economic growth by increasing the money supply and lowering interest rates. These mechanisms will, in theory, stimulate business investment as well as consumer spending.

However, in the current low interest-rate environment, the effectiveness of such policies is diminished. When short-term rates are already so close to zero, reducing them further will have little impact. To overcome this dilemma in 2008, central banks began experimenting with the unconventional monetary policy of QE to inject new money into the system by purchasing massive quantities of longer-term assets such as Treasury bonds.

These purchases are intended to increase the money supply while decreasing the supply of the longer-term assets. In theory, this should put upward pressure on these assets’ prices (due to less supply) and decrease their yield (interest rates have an inverse relationship with bond prices).

Navigating Uncharted Waters

QE falls under intense scrutiny due to a lack of empirical evidence so far.

Japan, known for its willingness to try unconventional monetary policies, was the first to try QE. Used to combat deflation in the early 2000s, Japan’s QE program was relatively small in scale, and saw mediocre results.

Fast forward to today, and QE is quickly becoming a cornerstone of the Fed’s policy toolkit. Over a span of just 12 years, QE programs have led to a Fed balance sheet of over $6 trillion, leaving some people with more questions than answers.

This is a big experiment. It’s something that’s never been done before.

Kevin Logan, Chief Economist at HSBC

Critics of QE cite several dangers associated with “printing” trillions of dollars. Increasing the money supply can drive high inflation (though this has yet to be seen), while exceedingly low interest rates can encourage abnormal levels of consumer and business debt.

On the other hand, proponents will maintain that QE1 was successful in mitigating the fallout of the 2008 financial crisis. Some studies have also concluded that QE programs have reduced the 10-year yield in the U.S. by roughly 1.2 percentage points, thus serving their intended purpose.

Central banks … have little doubt that QE does operate in many ways like conventional monetary policy.

Joseph E. Gagnon, Senior Fellow at the Peterson Institute for International Economics

Regardless of which side one takes, it’s clear there’s much more to learn about QE, especially in times of economic stress.

The Other Exponential Curve

When conducting QE, the securities the Fed buys make their way onto its balance sheet. Below we’ll look at how the Fed’s balance sheet has grown cumulatively with each iteration of QE:

  • QE1: $2.3 Trillion in Assets
    The Fed’s first QE program ran from January 2009 to August 2010. The cornerstone of this program was the purchase of $1.25 trillion in mortgage-backed securities (MBS).
  • QE2: $2.9 Trillion in Assets
    The second QE program ran from November 2010 to June 2011, and included purchases of $600B in longer-term Treasury securities.
  • Operation Twist (Maturity Extension Program)
    To further decrease long-term rates, the Fed used the proceeds from its maturing short-term Treasury bills to purchase longer-term assets. These purchases, known as Operation Twist, did not expand the Fed’s balance sheet, and were concluded in December 2012.
  • QE3: $4.5 Trillion in Assets
    Beginning in September 2012, the Fed began purchasing MBS at a rate of $40B/month. In January 2013, this was supplemented with the purchase of long-term Treasury securities at a rate of $45B/month. Both programs were concluded in October 2014.
  • Balance Sheet Normalization Program: $3.7 Trillion in Assets
    The Fed began to wind-down its balance sheet in October 2017. Starting at an initial rate of $10B/month, the program called for a $10B/month increase every quarter, until a final reduction rate of $50B/month was reached.
  • QE4: $6 Trillion and Counting
    In October 2019, the Fed began purchasing Treasury bills at a rate of $60B/month to ease liquidity issues in overnight lending markets. While not officially a QE program, these purchases still affect the Fed’s balance sheet.

After the COVID-19 pandemic hit U.S. shores, however, the Fed pulled out all the stops. It cut its target interest rate to zero for the first time ever, injected $1.5 trillion into the economy (with more stimulus to come), and reduced the overnight reserve requirement to zero.

Despite receiving little attention in the media, this third measure may be the most significant. For protection against bank runs, U.S. banks have historically been required to hold 10% of their liabilities in cash reserves. Under QE4, this requirement no longer stands.

No End in Sight

Now that the Fed is undertaking its most aggressive QE program yet, it’s a tough guess as to when equilibrium will return, if ever.

After nearly two years of draw-downs, Fed assets fell by just $0.7 trillion—in a matter of weeks, however, this progress was completely retraced.

QE4 is showing that what goes up, may not necessarily come down.

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