Long-term interest rates have remained low in the Group of Seven (G7) major industrial countries despite large fiscal deficits and rising public debts. Is this a sign that the factors affecting interest rates have changed? In this era of global capital mobility, is there, as some observers claim, a “new economy” of interest rates that involves a radically different relationship between interest rates and what have traditionally been considered as their determinants, including fiscal imbalances? A new IMF Working Paper argues that factors that are likely to be transitory have masked the effects of traditional determinants and lulled policymakers into a false sense of security. There may be a rude surprise in store, argue authors Manmohan Kumar and David Hauner.
Recent discussions of the evolution of global long-term interest rates have tended to ignore a marked deterioration in the fiscal positions of some of the largest industrial economies since the mid- to late 1990s. The ratio of public debt to GDP has risen very significantly over the past 10 years in Japan; in the other G7 countries the rise has been far less dramatic but still quite noticeable: in the United States it has risen by more than 4 percentage points since its trough in 2001, and in several large European Union countries, it has risen by between 5 and 10 percentage points.
While deficits and debts have risen, nominal and real long-term interest rates have remained very low (see chart) despite an up-tick in early 2006. Low long-term rates—by allowing government debt to rise without much increase in interest expenditures—reduce the incentive to address budgetary imbalances; in addition, the subdued behavior of bond yields—in the presence of fiscal imbalances as well as strong economic growth and a tightening of monetary policy in some cases—has prompted renewed doubts about the underlying links between government deficits and debt and interest rates.
Why rates could be low
While it is clear that long-run real interest rates should be determined by ex ante rates of saving and investment, empirical studies show that the determinants of both saving and investment, and, thereby, of real interest rates vary significantly across countries and over time. This is particularly true for the effects of government borrowing on interest rates. According to a widely cited survey (Gale and Orszag, National Tax Journal, 2003, “Economic Effects of Sustained Fiscal Deficits”), about half of 60 studies found that fiscal deficits had a “predominantly positive significant” effect on interest rates, with an increase in the deficit of 1 percent of GDP raising interest rates by about 30-60 basis points on average (the other 30 studies found mixed or predominantly insignificant effects).
High deficits, low interest rates
While Group of Seven government deficits have soared, long-term bond yields have stayed unusually low.
Source: IMF World Economic Outlook database.
Nominal interest rates have trended downward during the past two decades. There is wide agreement that this trend reflects expectations of lower inflation, underpinned by greater policy credibility and the increasingly competitive environment in the global economy. There is less agreement, however, on why long-term rates have recently stayed unusually low despite the cyclical upswing of world economic activity.
Some observers also attribute this recent behavior at least partly to lower inflation expectations. But long-term inflation expectations have not, in fact, declined over the past few years, at least in the United States, the country with the widest range of available measures of long-term inflation expectations.
If the decline in nominal interest rates did not reflect a decline in inflation expectations, real interest rates must have fallen. To some extent a fall in real rates could reflect the effects of rising liability-driven investments in the fixed-income markets by pension funds and insurance companies. More fundamentally, low real interest rates may be expected to result from a shortfall of planned investment relative to planned saving. An element of the explanation may therefore lie in the highly unusual fact that the corporate sectors in the United States and many other industrial and emerging market economies have become large net savers.
Another factor on which some observers have focused is the large current account surpluses of fast-growing emerging market or oil-exporting economies. They have emphasized the unprecedented accumulation of industrial country government securities by their central banks. Motivated by the need for “insurance” or being a side effect of the exchange rate regime, these purchases are likely to be relatively insensitive to expected returns.
In many large industrial countries, then, the effects of a “savings glut” may have more than offset the effects of rising fiscal deficits. So is there a “new economy,” in which domestic factors, particularly fiscal policy, are outweighed by global forces? To constitute a new economy, the drivers of interest rates would need to have changed.
No evidence of a new economy
An empirical analysis of the drivers of long-term interest rates in the G7 over 1960-2005, based on a model of interest rate determination in large open economies, finds no evidence that the relative importance of the drivers has changed. Rather, it is the evolution of some of the key drivers that accounts for the recent low interest rates. Though government borrowing has had a significant upward effect on interest rates, this has been outweighed by the downward effect of reserve accumulation. While fiscal deficits have added an estimated 50 basis points to G7 long-term interest rates, on average, during 2001–05, reserve accumulation subtracted up to 90 basis points.
The results are of concern because they suggest that the major downward influence on interest rates has been a factor that many observers believe to be transitory: unprecedented transfers of savings from the developing to the industrial world, prompted by insurance or exchange rate regime rather than investment motives and invested in fixed-income government securities.
Opinions vary on how long this phenomenon is likely to last, but the opportunity cost of accumulating these reserves (see IMF Survey, June 6, 2005) suggests that the process will at least need to slow down. Another element that is likely to slow the process is the medium-run prospect of an adjustment in global current account imbalances, which have been a key element in reserve accumulation.
As these transitory factors, or expectations about them, wane in significance, other determinants of interest rates, notably fiscal policy, may be expected to come to the fore again.
Though government borrowing has had a significant upward effect on interest rates, this has been outweighed by the downward effect of reserve accumulation.
In for a rude awakening?
Debt-to-GDP ratios were higher in 2005 than in 1990 in all G7 countries except Canada and the United States, and in the United States the ratio has risen substantially since its trough in the late 1990s. While higher debt usually means a higher interest bill, governments have been insulated from this effect this time: Italy, the United Kingdom, and the United States had to pay much smaller interest bills in percent of GDP in 2005 than on average during most of the 1990s. And France, Germany, and Japan still bear the same interest burden relative to GDP as they did 15 years ago, even though their debt has risen substantially. The quiescence of long-term interest rates is likely to have encouraged complacency about the long-term macroeconomic cost of higher deficits.
Once fiscal policymakers see interest rates return to “normal” levels, their awakening from the current benign environment could be made all the ruder by the consequences of continued recent fiscal deficits, which have added to public debt. Analysis shows that an increase of 100 basis points in the average interest rate on G7 countries’ debt would raise the G7 interest burden—expressed as a ratio to GDP—by 0.8 percentage point. Of course, the impact of higher interest rates would filter down to the interest burden only gradually. But even small increases in interest rates have a large cumulative long-term effect on debt developments.
Furthermore, in the long run, population aging in G7 countries may also push interest rates up, exacerbating the debt burden. This effect will be compounded if aging also drives up deficits as pension and health care costs accelerate. Though there is no consensus on the net effect of aging on interest rates, such a scenario is far from unlikely. And, given the high likelihood of a reversal in the factors that currently keep global long-term interest rates in check, recent budgetary developments in most of the G7 countries underline the need for budgetary consolidation over the medium term.
David Hauner and Manmohan S. Kumar
IMF Fiscal Affairs Department
This article is based on IMF Working Paper No. 06/112, “Fiscal Policy and Interest Rates—How Sustainable is the “New Economy?”” Copies are available for $15.00 each from IMF Publication Services. Please see page 144 for ordering details. The full text is also available on the IMF’s website (www.imf.org).