As the world economy has weakened over the course of this year, sointerest rates have come down. In the US, the cost of borrowing has fallento just 2% – from over 6% a year ago. The Fed funds rate is now at itslowest level for more than 40 years. In the eurozone, too, interest rateshave been decreased, they currently stand at just over 3% – while UKinterest rates are now at the lowest level we have seen since the1960s.
One important contributing factor to such low interest rates is thevirtual absence of inflation. For many years now, the inflation rate inmost industrialised countries has been hovering around 2%. In such a lowinflation world, interest rates might be expected to average around4.5-5%, with 2% or so providing compensation for rising prices and a realreturn of 2.5-3%.
In the old world of high inflation, interest rates of 5% or so would haveseemed exceptionally low. But while price increases remain so subdued, ourhorizons need to change.
At times of weakness in the world economy, we should expect interest ratesto fall below this 4.5-5% norm and that is exactly what is happening now.Interest rates have fallen most sharply in the US, where conditions haveweakened most abruptly. Economic activity is falling, confidence is weakand unemployment is rising. The US economy is almost certainly inrecession and will need a big boost to give it a kickstart and turn itback towards growth.
Part of that boost will come from the current low level of interest rates.Indeed, we should not rule out further rate cuts if the recessioncontinues to deepen. The government is also increasing spending andcutting taxes. The combined effect of these measures should be sufficientto lift US economic activity in the second half of next year, but the next6-9 months are likely to see more bad economic news as the recessionunfolds.
Similar arguments apply to a lesser extent in the UK and Europe. On thisside of the Atlantic, economic conditions are holding up better andoutright recession should be avoided. But growth has certainly slowed inthe UK and across the European Union, with some EU countries – notablyGermany – in danger of slipping into recession. We should not besurprised, therefore, if interest rates also continue to fall in the UKand the eurozone over the months ahead.
Most economists expect lower interest rates and supportive tax andspending policies to lift global economic activity over the course of nextyear. But what if that does not happen? Japan provides an ominous warninghere. Japanese interest rates have fallen to zero and yet the economystubbornly fails to recover. Could something similar happen in theWest?
The risks of a prolonged stagnation are probably greatest in the US, buteven here it is an outside possibility. But there are four important waysin which Japan is different. First, Japan is currently experiencingoutright deflation – falling prices – rather than the modest inflation wesee in the US and Europe. Deflation makes it harder for interest rates tostimulate economic activity as borrowing costs cannot fall below zero.
Second, there are severe and difficult to address problems in the Japanesefinancial system, which became embedded over the four decades of strongpostwar growth. The financial systems of the US and European countries arein much better shape, notwithstanding the impact of bad lending andinvestment during the internet bubble of the late 1990s.
Third, there are other structural problems holding back economic growth inJapan. These include a lack of flexibility in the services sector of itseconomy – which accounts for the bulk of employment. Finally, publicfinances are in better shape in the US, allowing greater scope for astimulus from fiscal policy. In Europe, the picture is more mixed, butpublic finances were put on a more sound footing than they had been ascountries prepared to adopt the euro in the late 1990s.
These differences suggest that a Japanese-style debt deflation should beavoided in Western countries. However, we should not be surprised ifinterest rates do need to fall further in the US and Europe to restoregrowth to the world economy next year. When growth resumes, interest ratesmay need to rise again. But while inflation remains so subdued, we need tobecome accustomed to living with much lower interest rates.