Could Interest Rates Return to Zero?

The Possibility of Ultra-Low Rates Returning

In 2009, central banks around the world slashed interest rates dramatically to near 0%. This was meant to be a temporary move to counter a short-term economic crisis. Markets and experts predicted rates would soon rise back to normal levels. However, for 13 years interest rates defied expectations, staying unusually low.

Just as zero rates seemed permanent, 2022’s inflation surge caused interest rates to soar rapidly. Inflation proved worse than anticipated, spurring rates higher than many foresaw. Yet by late 2023 inflation had started falling much faster than predicted. This begs the question – will the forces that kept rates near zero for over a decade return? Or is the new status quo one of high inflation and elevated interest rates?

Historical Downward Trend in Real Rates
Rates Have Been Falling for Centuries

Looking back, the long-term trend for real interest rates is downward. Rates have been declining for centuries. Specifically since the 1970s, rates have dropped markedly. So in the bigger picture, the recent period of ultra-low rates aligns with this gradual historical descent.

Reasons for Optimism on Inflation
Early Signs of Declining Price Pressures

In the near-term, there are grounds for optimism that inflation will keep moderating:

– Oil and gas prices have already fallen significantly in recent months
– Food prices are also down noticeably
– All the COVID-spurred supply constraints that drove 2022’s inflation seem to have eased
– China, the world’s foremost manufacturer, is undergoing deflation amidst a property downturn. This threatens to export further global disinflationary pressures, especially in Chinese-made goods

The UK had higher inflation than Europe and the US – it was an outlier, mainly due to high natural gas costs and Brexit-related food inflation shocks. But recent data shows the UK converging back in line with continental Europe and America.

Furthermore, the UK’s inflation was never caused by strong economic expansion and rising demand, the normal spark for inflation. Instead, it stemmed from cost-push pressures. Additionally, the prior interest rate rise from 0.1% to 5% will exert major downward pressure on demand, as over 1 million households refinance to higher mortgage rates.

Former Bank of England governor Andrew Haldane warns the UK now faces high risks of entering recession this year, or at minimum a prolonged period of stagnation. This will dampen inflationary pressures further.

Why Did Rates Stay at Zero for 13 Years?
The Theories Behind Ultra-Low Rates

So why did interest rates remain at rock-bottom levels for nearly 13 years after the 2009 cuts? The 2008 financial crisis triggered an unexpected plunge in demand, housing market crash, deep recession, and liquidity crisis. Banks became extremely reluctant to lend, even at 0% rates.

Quantitative easing (QE) was pursued since even zero rates proved insufficient to spur recovery. Some argue QE itself artificially suppressed bond yields over the past decade. However, this fails to explain why central banks maintained base lending rates at zero as well. If QE succeeded in boosting growth, we would have seen some resultant inflationary pressures and rate hikes.

One theory is “secular stagnation” – that advanced Western economies with aging populations no longer generate the same investment and growth levels. Growth has slowed across the developed world – Japan, Europe, the US, UK. There is a persistent shortfall of demand, leading to lower inflation. In this weak growth environment, central banks keep rates very low trying to incentivise investment.

Japan pioneered secular stagnation, mired in 20+ years of near-zero rates. Due to its aging population, Japan sees high savings appetite but little investment. If this lack of investment demand endures, it causes downward rate pressure. European nations face similar demographic headwinds to Japan – birth rates have plunged, and the population is set to decline. This kind of demographic shift will likely dampen investment but boost savings demand. Proponents argue that if secular stagnation theory holds, ultra-low rates could plausibly return.

Challenges to Secular Stagnation Theory
Ageing Populations Don’t Necessarily Mean Low Growth

Admittedly the above outlook may seem overly optimistic given core inflation remains near 6% – three times above the 2% target. Nominal wage growth is still strong too, as workers aim to recover lost purchasing power. Expectations have also shifted – people no longer presume perpetually low inflation and rates like before. Plus, recent commodity price drops could easily reverse. While Chinese demand has depressed oil prices, any new geopolitical crisis could quickly resurge inflation.

Additionally, the secular stagnation hypothesis has its doubters. They contend the 2010s growth struggles were more a hangover from the 2008 crisis’ unique characteristics– a rare property crash and widespread bank balance sheet damage. Despite some exposure to higher rates, banks aren’t experiencing the same financial calamity today.

Looking ahead, governments face pressures to borrow and invest more in the net zero transition and infrastructure drives. Areas like housing, climate adaptation and artificial intelligence could also stimulate private investment. So it may be overly simplistic to say aging populations guarantee lower investment and growth.

Finally, as central banks unwind QE, this will likely push bond yields and rates higher over time. Another key factor is productivity growth – if the economy sees technology gains and falling business costs, it can expand without stoking inflation. But zero productivity growth meant even minor UK growth spilled over into inflation.

Are Ultra-Low Rates Likely to Return?
Interest Rate Predictions Are Challenging

This analysis is not outright predicting a return to rock-bottom, zero rates in the next few years. However, given we spent 13 years with ultra-low rates, it’s certainly plausible this climate could resume. Just as inflation rose higher than most economists anticipated, it then also fell faster than forecast.

This underscores how hard accurately predicting rates can be. In 2006-07, near-zero rates seemed unfathomable. And in 2009, no one envisioned 13 straight years at that emergency level. Likewise at 2022’s start, how many genuinely expected 14 back-to-back UK base rate rises?

Ultimately while low rates may benefit heavily indebted consumers, extended periods of ultra-cheap credit have downsides for the broader economy. Near-zero rates often distort investment into unproductive assets like housing instead of manufacturing. They also force central banks to turn to experimental policies like QE as their main stimulus tool. Arguably the 2010s obsession with ultra-low rates also sparked asset price inflation, even without actual consumer inflation.

So rather than hoping for another decade of rock-bottom rates, achieving a balance of moderately higher rates and consistent growth would be a healthier economic outcome overall. But another plunge into zero rate territory still cannot be ruled out.