The fall in interest rates

" THE story of rich-world central banks and their protracted entanglementwith near-zero interest rates was given another twist this week. One of their number gamely announced it still hoped for a more distant relationship, even if it couldn’t bring itself to turn its back on them yet. Another renewed its vows to stick with them.…"                                                    -- THE ECONOMIST | Sep 24th 2016

This week’s Economist has called attention to the proverbial elephant in the room: Interest rates are persistently low. The article gives two reasons for this predicament: The first is the changing demography in most rich economies and also some emerging markets. Savings have increased to pay for a longer retirement, causing real interest rates to fall steadily. The second is the integration of China into the world economy. With savings rate at 40% of disposable incomes, China brings a lot of supply to the table.
 

With belated awareness, policy makers realize that the drop in real interest rates is not a symptom. Instead it reflects a shift down in underlying trend growth. While the historical relationship between real interest rates and economic growth is weak, the reason behind the low rates – that is, excessive saving – has come to dominate the demand for goods. In short, global output has slowed.

The higher propensity to save means the neutral real rate is lower than in the past. To gauge this, consider how much money the central banks have printed via the many rounds of Quantitative Easing in the past eight years. This has pushed interest rates and bond yields close to zero. If these were too low, it should lead to overheating and rising inflation. So far, there are no signs of this.

Indeed, well-intentioned attempts to guard against the impact of low rates may perversely become a cause of even lower rates. For instance, to stem rising home prices, some banking regulators have put draconian limits on mortgage borrowers. Unfortunately, that has dampened demand and fatally slowed the economy’s healing process. The inability to achieve “escape velocity” ensures that real rates are kept low for extended periods of time.

 
So what next? Each new round of central bank actions seems to bring less stimulus and more side effects. But all is not lost. The long-abandoned concept of using fiscal policy to fine-tune the economy went out of style when, in the 1970s, economists tried to work out why real interest rates were unusually high. Perhaps it is time to dust the idea down.

Reference:
http://www.economist.com/news/briefing/21707553-interest-rates-are-persistently-low-our-first-article-we-ask-who-or-what-blame