Four factors keeping interest rates low

1. Demographics

Over the past 30 years, there has been a significant increase in both life expectancy and the average age of the population. This means that more people are expecting to spend longer in retirement, creating more incentive to save rather than consume. This a global phenomenon but it is more advanced in high-income countries.

40 has become the new 30

Median population age globally and in high-income countries 

^{Source: UN, 2019}

This has a double whammy effect. The swelling ranks of the middle aged will be forced to invest for their retirement, rather than spending on goods and services. This reduces growth, forcing central banks to keep short-term interest rates lower than might otherwise be the case. It also boosts demand for government bonds, depressing both short- and long-term yields. Pension funds looking after these huge pools of retirement savings often have little choice but to invest in government debt, however low the income on offer.

2. National debt

Government debt levels were on a long-term upwards path even before the pandemic. Covid-19 has caused them to lurch higher.

Government debt has jumped ahead of output

Government debt in advanced economies as a percentage of GDP

^{Source: IMF, 2021}

The situation is manageable because low interest rates mean debt servicing costs are also low. However, that might not be the case if governments were forced to refinance in a higher rate environment.  

This puts pressure on central banks to keep rates low. This could take the form of overt political pressure, undermining central banks’ independence. Even if central bankers have the stomach to stand up to governments, markets may force them into submission.

3. Global reserves

There is another big accumulation of savings putting downward pressure on global interest rates: global currency reserves. Following the Asian financial crisis of 1998, many emerging market countries significantly increased their foreign exchange reserves, primarily US dollars, as a defensive measure. These investors have been willing to pay a premium for safety and liquidity, putting further pressure on global interest rates.

Officials responsible for investing these huge pools of money cannot invest freely; they are required to hold safe assets – US Treasuries in particular. This has been a key driver of the increase in foreign ownership of US government bonds. On the eve of the pandemic, international investors owned around a third of US debt. This has fallen as a result of the Federal Reserve’s huge bond buying programmes, but overseas investors still account for over a quarter of the market.

4. Inflation

Falling inflation – or disinflation – has been an important driver of lower interest rates over the past thirty years. When inflation is high or rising, savers and investors require a higher rate of return to compensate them for their loss of purchasing power. The reverse has been true for many years.

Before the pandemic, inflation remained low despite buoyant job markets in most developed economies. This unexpected outcome was the result of long-term structural trends, such as  globalisation and technology. In very competitive sectors, companies have less power to raise prices. Meanwhile, new and disruptive business models allowed them to provide goods and services more cheaply than ever before.

Prices rising at a slower rate

Personal Consumption Expenditures Excluding Food and Energy, Annual Percent Change, Seasonally Adjusted

^{Source: Federal Reserve Bank of St. Louis}

The long-term impact of the pandemic on inflation remains unclear. We are now seeing a pick-up in inflation as a result of higher commodity prices, bottlenecks in some parts of the economy and sharp price rises in the service sector (air travel, hotels, and hire cars are much more expensive than a year ago!). These could well be “transitory” impacts, as the Fed has suggested. The bigger question is whether the huge increase in the money supply we have seen over the past year will translate into price rises in the real economy.

There is good reason to think that technology could continue to limit price increases. We are only just starting to see the potential of robotics and artificial intelligence, for instance. Both could have a significant impact on employment, unleashing a new round of disinflationary pressure.