Why does a rate hike not cause inflation?

Low interest rates - macroeconomic causes and consequences

The central banks in the industrialized countries have been pursuing a very loose monetary policy with low nominal interest rates for a long time. If the inflation rate is low, real interest rates are also very low. Low interest rates are expected to overcome investment weakness, halt deflationary developments and stimulate economic growth. Apparently, however, monetary policy cannot achieve these goals on its own; it may even set the wrong incentives. Other regulatory measures are required, and investment programs can also have a supportive effect.

Did the central banks miss the timely exit from the low interest rate policy?

Oliver Landmann

Since the central banks of the major industrialized countries drastically cut their key interest rates in the wake of the financial crisis of 2008 and the subsequent global recession, short-term interest rates have remained near zero. Long-term interest rates, adjusted for risk, are only slightly above this. The low interest rate environment and the ample liquidity that goes with it have indeed spurred the asset markets. But the recovery of the real economy from the crisis has started slowly and unevenly; in large parts of Europe, production has still not returned to pre-crisis levels.

Against this background, the effects of the record low interest rates are the subject of controversial discussion. If a medicine does not work as expected, there can be two reasons. Either the medicine is right, but the dose is too low. Or the patient is receiving the wrong medicine. Most central banks have adopted the first of these interpretations. Using unconventional methods of expanding liquidity (quantitative easing) and expectation management (forward guidance), they are trying to provide those additional impulses that they can no longer provide with conventional interest rate policy, given that the lower limit of zero interest rates has been reached.

Business cycle, financial cycle and the Bank for International Settlements Doctrine

Critics of the loose monetary policy, on the other hand, question its effectiveness and warn of undesirable side effects. The main concern is that cheap money will encourage the formation of new speculative bubbles in the financial and real estate markets. This position is articulated particularly pointedly by the Bank for International Settlements (BIS). In its June 2014 annual report, the bank argues that the business cycle, which is usually the focus of attention in macroeconomic stabilization policies, is overlaid by a financial cycle.1 It measures it mainly in terms of movements in house prices and credit aggregates and interprets it as an expression of itself self-reinforcing interactions between risk appetite, assets and funding restrictions that underlie the sequence of boom phases and crises in the financial markets. The wavelength of the financial cycle is longer than that of the business cycle. However, peaks in the financial cycle are often followed by financial and banking crises, which in turn usually lead to a slump in the economy.2 A “balance sheet recession” occurs, 3 caused by a protracted reduction in private debt Sector and therefore lasts longer and is more difficult to overcome than a conventional stabilization recession typical of the post-war period.

The BIS complains that the central banks' monetary policy is too focused on current inflation and economic developments and does not pay enough attention to the financial cycle - with detrimental consequences not only for financial market and bank stability, but also for the stabilization of the price level and the economy. The most recent example: the central banks reacted to the economic slowdown following the bursting of the “dot-com bubble” in 2000 with a strong increase in liquidity, even though the financial cycle was in the middle of an upswing. The result - according to the interpretation of the BIS - was an increase in credit growth and a boost in property prices, which stimulated each other, but ultimately culminated in the financial crisis of 2008. The financial crisis, in turn, brought about an economic crisis, the dimensions of which soon overwhelmed the macroeconomic stabilization capacity of the central banks. This also disavowed the “Greenspan Doctrine”, which basically stated that the central banks should not try to identify and combat speculative bubbles in the financial markets, but should limit themselves to the consequences of a crisis, if one should bursts to catch up with a sufficiently accommodative monetary policy. 4

The BIS is concerned that something similar could happen again due to the enormous glut of liquidity with which central banks have countered the financial and banking crisis since 2008. She diagnoses a real “debt trap”: low interest rates encourage the private sector to take on debt, make it easier for banks to leave ailing old debts on their books, and tempt governments to postpone overdue budget consolidations. Conversely, high levels of debt in the private and public sectors make central banks shy away from raising interest rates as early and to the extent as they should

From this analysis, the BIS draws four conclusions: 6

  1. Low interest rates do not lead to excessive indebtedness, nor are they a particularly effective means of overcoming the ongoing economic weakness.
  2. Therefore, when fighting the crisis, politicians should focus less on expansionary demand policies than on balance sheet restructuring, supply-side structural reforms, and strict banking supervision and financial market regulation.
  3. The central banks should get out of the low interest rate policy as soon as possible.
  4. Governments should accelerate the consolidation of their budgets.

Two questions arise: First, is the diagnosis correct? Second, how would countries that have not yet overcome the recession cope with the prescribed therapy?

Monetary policy systematically too loose?

The BIS supports its diagnosis of a systematically too loose monetary policy, disregarding the financial cycle, with the observation that the interest rate level has been showing a falling trend since the 1980s. This trend is a well-documented fact. But what is the cause and what is the effect? The reference variable used to measure whether monetary policy is restrictive or expansionary is the long-term real equilibrium interest rate - in Knut Wicksell's terminology: the natural interest rate.7 All the indications suggest that the natural interest rate has been falling for a long time. The causes lie primarily in fundamental changes in global savings and investment behavior: demographic aging and declining growth dynamics in the industrialized countries as well as the high savings surpluses in the emerging countries.8 The money and interest theory from Knut Wicksell to Milton Friedman up to The modern New Keynesians largely agree that monetary policy cannot influence real interest rates over the long term.

Monetary policy pursues macroeconomic stabilization by temporarily raising the market interest rate above the equilibrium rate or lowering it below the equilibrium rate. It is clear that any assessment of central bank behavior that ignores the downward trend in natural interest rates - whether based on time series properties of interest rates or using a Taylor rule as a yardstick - runs the risk of fluctuations in the level of interest rates to misinterpret the downward trend as an asymmetrical behavior of the central banks that systematically tends to cut interest rates. If this interpretation were correct, the falling interest rate trend should have been accompanied by rising inflation rates. However, since inflation rates have fallen significantly at the same time as the real interest rate, the central bank interest rates are likely to lag behind the falling trend of the real equilibrium interest rate on average.

The persistence of the balance sheet recession despite nominal interest rates and inflation rates that are no longer far from zero suggests that the natural interest rate has fallen into negative territory due to the simultaneous saving efforts of the private and public sectors (“deleveraging”). Since under these circumstances there are no forces at work that could work towards a rebound in inflation rates, interest rates remain above their equilibrium level. Monetary policy is therefore systematically too restrictive, but it can do little to change this as long as its hands are tied by the liquidity trap. It is no coincidence that the ghost of “secular stagnation”, believed to be dead, is being discussed again as a real threat.9

The diagnosis of the balance sheet recession explains why the transmission mechanisms of demand policy are weakened. But to draw the conclusion from this that politicians, if they want to get growth going again, must shift the weighting from instruments of demand management to those of supply-side structural reforms and financial market regulation, misjudges the nature of the problem. The debt reduction pursued everywhere is turning the demand for goods into a binding bottleneck. Political measures to strengthen the supply side of the economy and to increase financial market stability do nothing directly to ease this bottleneck. In some cases, they actually do the opposite. It is therefore wrong to treat supply and demand-side instruments of economic policy as substitutes or even to play them off against one another. As indisputable as the need for long-term structural reforms may be, such reforms can do little if they are not flanked by a sufficiently accommodating demand policy. The concept of a “two-handed approach”, which was coined years ago and promotes supply-side and demand-side measures as complementary instruments of macroeconomic stabilization, has lost none of its topicality

Can monetary policy be the servant of two masters?

Even if the central banks of the industrialized countries cannot be accused, from the point of view of their direct effects on the economy and price level, of having systematically pursued too loose a policy, it cannot be denied that the low interest rates occasionally had side effects that were long underestimated. Phases in which growth rates are higher than interest rates favor credit growth and speculative exaggerations in asset prices and thereby undermine financial market stability - especially when market participants tend to extrapolate the prevailing conditions into the future and fail in their behavior strict regulation can be restricted. It is also true that many governments did not use the favorable macroeconomic environment and low interest rates to consolidate their budgets on a sustainable basis and prepare them for future crises, but rather saw them as an opportunity to take on further debt without directly increasing the debt burden .

This means that monetary policies adequate to control the business cycle and inflation cannot simultaneously tame the financial cycle and provide appropriate incentives for sustainable public finances. She cannot be the servant of two (let alone three) masters. However, this is exactly what the BIS doctrine described above demands when it postulates as a lesson from the financial crisis not only a tightening of banking supervision and financial market regulation, but also a monetary policy that takes the financial cycle into account. Although not precisely described by the BIS, this would amount to a balancing act that is supposed to somehow bridge the tension between macroeconomic stability and financial market stability.

In favor of this approach, it can be argued that a financial cycle that has gotten out of hand can set developments in motion that ultimately destroy not only financial market stability but also macroeconomic stability. But rational economic policy is not about asking monetary policy to do more than it can do. According to the Tinbergen principle, economic policy requires as many independent instruments as it pursues goals.11 Furthermore, economic policy theory teaches that in an interdependent system of goals and instruments it does not make sense if one instrument is used on all interdependencies and Taking goals into account. A clear, appropriate allocation of responsibilities is much more efficient. 12

What this actually means in the present context is illustrated in Figure 1. It shows the three stability goals of financial market stability, macroeconomic stability and stability of public finances as well as the three policy areas of monetary policy, financial policy and financial market order. The dense networking of goals and policy areas, illustrated schematically by arrows, shows that each political action parameter directly or indirectly influences each of the goals. Janet Yellen, chairwoman of the Federal Reserve Board, recently admitted that tightening monetary policy in the run-up to the financial crisis would have reduced some of the risks to financial stability. However, she also points out that the dependence on very short-term credit in the financial sector increased further before the crisis even after monetary policy had already tightened the reins noticeably. This suggests that more aggressive interest rate hikes would have been a poorly targeted instrument with regard to the prevention of a financial crisis and thus a poor substitute for more effective financial market regulation. 13

illustration 1
Solving the assignment problem

Source: own illustration.

It is therefore inexpedient to hold monetary policy accountable for objectives other than macroeconomic stability. Rather, each policy area must be assigned and subordinated to the objective for which it has a comparative advantage, i.e. is relatively most effective. The type of assignment is obvious in the present case and is marked in Figure 1 by the blue effect arrows. Financial market stability should be striven for by means of suitable rules and institutions of the financial market order. With regard to fiscal policy, there is broad consensus that the objective of macroeconomic stability should normally be left to monetary policy. However, if the latter is not available, for example because it has lost its effectiveness in a liquidity trap or because it has been delegated to the common central bank in a monetary union, fiscal policy still has a role to play in maintaining macroeconomic stability (dashed arrow in figure 1) .14

Conclusion: no hasty exit from the low interest rate policy!

What would have been a dubious strategy before the crisis would be even more so under the conditions of continued undershoot of inflation targets and persistent growth weakness, which are currently still characteristic of the euro zone in particular. A premature exit from the low interest rate policy would not accelerate the reduction of excessive debt, but slow it down, and not reduce the deflationary pressure, but exacerbate it. A strategy that amounts to taking the real economy hostage with deflationary monetary policies so that financial markets do not create threatening risks or that governments actually do their homework would be an inefficient and costly misallocation of responsibilities and therefore doomed to failure.

  • 1 See Bank for International Settlements, 84th Annual Report, Basel, June 29, 2014.
  • 2 Ibid, Chapter IV.
  • 3 The term comes from R. Koo: The Holy Grail of Macroeconomics, New York 2009.
  • 4 Cf. W. White: Should Monetary Policy Lean or Clean? Globalization and Monetary Policy Institute, Federal Reserve Bank of Dallas, Working Paper 34, August 2009.
  • 5 Bank for International Settlements, loc. Cit., Chap. IV.
  • 6 Ibid., Chap. I.
  • 7 K. Wicksell: Money interest and prices of goods, Jena 1898.
  • 8 The phenomenon is analyzed in detail in: International Monetary Fund: World Economic Outlook, April 2014; and in C. Teulings, R. Baldwin (Eds.): Secular Stagnation, Facts, Causes, and Cures, A VOXeu.org eBook, Center for Economic Policy Research, London 2014.
  • 9 C. Teulings, R. Baldwin (eds.), Loc. Cit.
  • 10 The idea of ​​the "two-handed approach" goes back to O. Blanchard, R. Dornbusch, R. Layard (eds.): Restoring Europe’s Prosperity, Cambridge 1986.
  • 11 J. Tinbergen: On the Theory of Economic Policy, Amsterdam 1952.
  • 12 The allocation problem was first solved by Robert A. Mundell in the context of stabilizing an open economy: R. A. Mundell: The Appropriate Use of Monetary and Fiscal Policy Under Fixed Exchange Rates, IMF Staff Papers 9, 1962, pp. 70-77.
  • 13 See J.Yellen: Monetary Policy and Financial Stability, The 2014 Michel Camdessus Central Banking Lecture, International Monetary Fund, Washington DC, July 2014.
  • 14 Considerations on the design of fiscal policy rules that take account of the need for such a conditional allocation, in: J. Portes, S. Wren-Lewis: Issues in the Design of Fiscal Rules, Oxford University, Department of Economics, Discussion Paper, No. 704 , May 2014.

What are the dangers of low interest rates?

Jens Boysen-Hogrefe, Nils Jannsen

In the wake of the global financial and economic crisis, the central banks have massively lowered their key interest rates in many places and have taken other measures such as “quantitative easing” or “forward guidance” to make their monetary policy even more expansive. The European Central Bank (ECB) recently cut its key interest rate to 0.15% and announced that it is likely to keep it at this low level for a longer period of time.

According to the interpretation of the ECB and its monetary policy concept, it seems appropriate that it is likely to leave its key interest rate at a very low level for a long time; Inflation in the euro area is well below the ECB target and there are still no signs of a major economic recovery.1 Nonetheless, a pronounced phase of low interest rates can result in serious stability policy risks. This applies in particular to economies such as Germany, which are evidently in a significantly more favorable economic situation than other economies in the monetary union, so that the monetary policy of the ECB, which is based on developments in the entire currency area, is clearly too expansive for Germany In addition, other factors - in particular the perception of foreign investors of Germany as a safe haven - also contribute to the generally very low interest rate level in Germany. However, this effect is likely to have lessened significantly recently - also due to the announcement of Outright Monetary Transactions - as can be seen from the significantly lower risk premiums for government bonds in the euro area.

In the following, we discuss possible risks that could result from the prolonged phase of very low interest rates for the German economy, and point out recommendations for action for politicians. The focus is currently on three risks, namely risks for old-age provision, for public budgets and for financial market stability

Risks to retirement provision

For some time now there has been increasing reference to the negative consequences of low interest rates for “savers” and warnings that the ECB's interest rate policy could lead to a wave of old-age poverty. It is argued that the returns on fixed income investments are currently very low and that such investments may even lose real value from time to time. However, the phenomenon of negative real interest rates on conservative forms of savings such as overnight money and savings accounts is not uncommon. Bundesbank data suggests that negative real interest rates were more the rule than the exception in the past for these very safe forms of investment (see Figure 2). From this point of view, the risks for retirement provision have consequently not increased significantly.

Figure 2
Real interest rates on savings

Source: Deutsche Bundesbank.

For a comprehensive assessment of the risks, however, it is not enough to focus solely on fixed-income forms of investment. The effects on old-age provision result from a number of direct and indirect consequences of the low interest rate phase, which can range, for example, from private households' propensity to save, to the consequences for funded old-age provision and future price developments, to effects on statutory pension insurance also differ greatly from one individual to the next. It is therefore anything but trivial to estimate the risks that arise from the low interest rate phase for old-age provision. It should be noted in particular that there is no historical experience with long periods of extremely low nominal interest rates.

However, there are already increasing risks for the providers of old-age provision products. Banks and insurance companies have offered long-term savings contracts with nominally guaranteed interest rates or are still doing so; For life insurance, the so-called maximum technical interest rate is even regulated by the state.4 Very few providers of these products are likely to have calculated with such a long period of nominal low interest rates, so that they would not have entered into long-term contracts to generate the guaranteed interest. Thus, there could be acute risks for old-age provision through possible insolvencies of providers of long-term savings contracts. The insolvency of such providers could on the one hand jeopardize individual parts of the pension scheme and on the other hand impair the stability of the financial system

Risks to public budgets

The generally low level of interest rates has recently given the public budgets massive relief. In addition to the low central bank interest rates, this is also due to the perception of federal bonds as a “safe haven” .6 Overall, public budgets can refinance expiring bonds and loan agreements at significantly more favorable conditions than in the years before the financial and economic crisis. Since there are still bonds in circulation that were issued before this time, these relief effects for public budgets are likely to increase even further. The effects are now considerable. In 2009 the federal government was still anticipating interest expenditures of 52 billion euros for 2013. In fact, “only” 31 billion euros were spent, although the debt level actually increased noticeably during this period.7

As a result, Federal Finance Minister Wolfgang Schäuble recently announced a balanced budget for 2015. Even if, in view of recent economic risks and additional uncertainties, such as the question of the future of the nuclear fuel tax, it is not certain that this goal will actually be achieved, the federal government should comply with the debt brake requirements without any problems. Apart from a few interventions in financial relations with the social security system, this was achieved without major consolidation efforts. Seen in this way, the citizens also benefit from the low interest rates in the form of no cuts in benefits and tax increases.

But there is a particular danger here. The need for consolidation in order to comply with the debt brake, which became apparent a few years ago, has not finally vanished into thin air, but is being masked by the low and in some cases still falling interest expenditure. In the course of calculating the structural budget balance relevant for the debt brake, interest expenditure is not smoothed. They are considered "structural". Should the financial policy "only" meet the debt brake requirements in the coming years and use the apparent leeway, e.g. for additional expenditure, a turnaround in interest rates would immediately generate consolidation pressure. Should the turnaround in interest rates go hand in hand with an economic slowdown in Germany, the necessary consolidation would come at an inopportune time

Risks to financial market stability

The prolonged phase of low interest rates can pose considerable risks to financial market stability, among other things because low interest rates encourage excessive risk appetite and lending by financial market players. An increased risk appetite in phases of low interest rates can be explained in part by the fact that financial market players (such as life insurance providers) take greater risks in order to be able to meet promised returns. In addition, periods of pronounced low interest rates can have a massive impact on the actors' risk perception. In such phases, asset prices or loan collateral as well as potential returns are often overestimated and as a result risks, for example when granting loans, are underestimated. As a result, banks tend to lower their credit standards noticeably during periods of low interest rates and also to extend loans to borrowers with lower credit ratings. 9

This is also one of the reasons why the loan volume often increases sharply in phases of low interest rates. As a result, the financial sector is not only becoming more vulnerable overall to negative “shocks”, but also to an increase in interest rates, for example as a result of a tightening of monetary policy. A strong expansion of the credit volume becomes particularly threatening if it is accompanied by a massive misallocation of capital and thus also with massive distortions in the real economy. Such misallocations have regularly occurred in the past in real estate markets during periods of low interest rates. As a result, previous financial crises were preceded not only by sharp increases in credit volume but also by sharp increases in real estate prices

However, it is difficult to assess whether the stability of the financial markets in Germany is already in serious danger or a new financial crisis is imminent. Financial crises are often the result of years of undesirable developments. When exactly these undesirable developments will pile up in a financial crisis can hardly be foreseen.11 For this reason, early warning systems for financial crises usually aim to identify typical undesirable developments. Such early warning systems would typically indicate increased risks for a financial crisis in Germany if at the same time the credit volume and real estate prices increase noticeably and deviate significantly from their trend developments

Against this background, the risks to financial market stability in Germany are apparently still manageable. This is supported above all by the fact that lending has hardly taken off in Germany so far. The credit volume has only been pointing slightly upwards again since 2011 and is well below its longer-term trend (see Figure 3 a).

Figure 3
Development of credit and real estate prices in Germany, 1991 to 2014

Notes: Volume of credit: Private non-financial sector. Real estate prices: In relation to consumer prices. The trend was estimated using the Hodrick-Prescott filter. The smoothing parameter lambda was set to 400,000 for this.

Source: Bank for International Settlements: Long series on credit to the private non-financial sector; Federal Reserve Bank of Dallas: International House Price Database.

Nevertheless, in Germany in particular, potential risks to financial market stability should be monitored with particular caution in the coming years:

  1. Real estate prices have been pointing up again for some time. In relation to the general consumer price trend, they have increased by almost 10% since 2008 and are already well above their longer-term trend (see Figure 3 b).
  2. Interest rates are likely to remain at a very low level for Germany for a longer period of time, which means that the risks for Germany are likely to gradually increase. This could be particularly evident in the event of a noticeable increase in lending in Germany.
  3. Early warning systems can only warn of crises that have the same characteristics as previous crises. Even if there are such typical characteristics of financial crises, they do not always follow the same pattern and it is not trivial to identify the underlying undesirable developments in a timely manner.

A good example of this is the recent financial crisis in Germany, which was "imported" into Germany via international financial links, but which is not due to exaggerations in domestic lending or on the domestic real estate market.13 As a result, typical early warning systems for financial crises (e.g. based on the loan volume and real estate prices) in the case of Germany did not give any warning signals.

Recommendations for action for politics

All in all, the long-term phase of low interest rates results in considerable stability policy risks for Germany in the medium term, especially for public budgets and financial market stability.14 Financial and economic policy is not entirely exposed to these risks (even within a currency union). There are numerous options for action that would not only contain the risks for the German economy, but would also make it more crisis-proof overall.

With regard to public finances, financial policy should react to the phase of low interest rates with pronounced risk provisioning - in this case the risk of an interest rate reversal - and, in the current situation, reduce debt (in relation to economic output) much more quickly than the provisions of the debt brake provide. This could be operationalized if, when calculating the structural budget balance, not the actual interest payments, but imputed interest that result from long-term average interest rates are used.15 Conversely, it should be avoided at all costs to use the apparently favorable budget situation for spending programs.

With regard to financial market stability, it is of paramount importance to use suitable macroprudential measures to make the financial system more crisis-proof and to strengthen the principle of liability. Some of the instruments proposed in the Basel III framework will contribute to this, in particular the higher capital requirements, the introduction of a capital conservation buffer and a debt limit to leverage capital. However, these instruments should be introduced more quickly and more restrictively in Germany than the Basel III framework provides. In addition, commercial banks should be increasingly obliged to issue bonds in the future in the form of conditional convertible bonds. The implementation of these measures would pay off twice. Not only would the financial system become more stable overall, but it would also counteract the emergence of dangerous credit-driven boom-bust cycles in asset prices.

  • 1 We will not discuss at this point whether the ECB's measures that go beyond lowering the key interest rate are effective and appropriate.
  • 2 For a detailed analysis of the ECB's monetary policy from the perspective of Germany, see J. Boysen-Hogrefe et al .: Financial and Economic Policy in the Event of Sustained Monetary Expansion, Kiel Contributions to Economic Policy, 5th year (2014).
  • 3 In addition, there may be other risks for the German economy, e.g. for price level stability, for growth prospects or for the labor market. For a detailed description, see ibid.
  • 4 The statutory maximum actuarial interest rate for life insurances for new contracts was recently reduced to 1.25%.
  • 5 It is to be expected that in such cases there would be government intervention in order to stabilize the system. However, regulatory problems can be associated with this. The recently state-decreed redistribution of profit sharing from old contracts to new contracts represents a serious encroachment on property rights.
  • 6 Cf. J. Boysen-Hogrefe: The interest burden of the federal government in the debt crisis: How lucrative is the “safe haven” ?, in: Perspektiven der Wirtschaftsppolitik, 13th year (2012), special issue, pp. 81-91.
  • 7 The situation is similar for the federal states. In 2009, North Rhine-Westphalia had expected interest expenses of 5.9 billion euros for 2013, but actually had to raise 3.9 billion euros.
  • 8 In this context, the risks for the public budgets are also increased by the fact that a long-term monetary boom is likely to result in considerable additional income and additional under-spending, which, although mainly due to the economic situation, could at least in part be assessed as structural.
  • 9 Cf. e.g. R. G. Rajan: Has Financial Development Made the World Riskier ?, NBER Working Paper 11728, National Bureau of Economic Research, Cambridge MA 2005; L. Gambacorta: Monetary Policy and the Risk-Taking Channel, in: BIS Quarterly Review, December 2009, pp. 43-53; A. Maddaloni, J.-P. Peydro: Bank Risk-Taking, Securitization, Supervision, and Low Interest Rates: Evidence from the Euro-Area and the US Lending Standards, in: Review of Financial Studies, Vol. 24 (2011), H. 6, p. 2121 -2165.
  • 10 Cf. e.g. M. Drehann, C. Borio, K. Tsatsaronis: Characterizing the Financial Cycle: Don’t Lose Sight of the Medium Term !, BIS Working Paper 380, 2012.
  • 11 The pile-up of such undesirable developments can prove to be problematic for an economy even if it does not lead to a financial crisis. For example, pronounced boom-bust cycles in the real estate market often lead to a noticeable slump in economic output even if they are not accompanied by a financial crisis. See e.g. N. Jannsen: Macroeconomic Effects of Real Estate Crises in Historical Comparison, in: N. Rottke, M. Voigtländer (Ed.): Immobilienwirtschaftslehre. Volume II - Economics, Cologne 2012, pp. 299-328.
  • 12 See e.g. C. Borio, M. Drehmann: Assessing the Risk of Banking Crises - Revisited, in: BIS Quarterly Review, March 2009, pp. 29-46.
  • 13 Of course, the financial crisis in Germany was comparatively mild compared to financial crises, which were accompanied by sharp increases in the volume of credit and property prices, as the sharp slump in economic output was followed by a strong recovery.
  • 14 For a detailed discussion of economic policy measures in response to sustained monetary expansion, see J. Boysen-Hogrefe et al., Op.
  • 15 Cf. J. Boysen-Hogrefe: Low interest rates and rapid monetary expansion: What should financial policy do ?, Institut für Weltwirtschaft, Kiel Policy Brief, No. 75, Kiel 2014.

Low interest rates make sense, but they cannot solve problems in Europe on their own

Ferdinand Fichtner

For several years now, monetary policy in many industrialized and emerging countries has followed a decidedly expansionary course. In addition to the expansionary interest rate policy, other measures to provide liquidity were also taken to counter the massive decline in lending in the wake of the global recession and financial crisis. While the reins of monetary policy are gradually being tightened again elsewhere, the expansionary orientation of monetary policy in the euro area reached a preliminary climax in early June 2014 when the European Central Bank responded to the risk of a deflationary spiral with a broad-based package of measures. In addition to a further reduction in key interest rates - and thus accepting negative deposit rates - it has decided to take measures to encourage banks to lend to companies and households in the euro area.

The expansionary monetary policy was accompanied by a significant decline in nominal interest rates in the euro area. In all member states of the monetary union, lending rates fell significantly in the course of the global economic and financial crisis (see Figure 4). Since the beginning of the crisis in the euro area, interest rates have gradually risen again, because on the one hand capital inflows from abroad have decreased significantly and, on the other hand, the banks in the monetary union have made their lending conditions much more restrictive. This countermovement was particularly pronounced in the crisis countries, while the other countries and especially Germany benefit from stable low interest rates from the fact that more and more capital is being shifted there from the crisis countries in search of safe investment opportunities.

Figure 4
Nominal lending rates1 in the euro area

1 Loans up to 1 million euros, variable or with an initial fixed interest rate up to one year.

Source: Deutsche Bundesbank.

Redistribution from savers to debtors

In Germany in particular, the interest rate trend is providing the public budgets with considerable additional leeway.1 On August 14, 2014, interest rates on newly issued ten-year German government bonds fell below 1% for the first time. According to calculations by the Bundesbank, the average interest rate on German government debt has fallen from a good 4% in 2007 to around 2½% in 2013; 2 per year, this decrease results in an arithmetical relief compared to a scenario in which interest rates are assumed to be at the 2007 level , of around 30 billion euros. For the creditors of the states, however, the lower interest rates lead to a correspondingly lower yield on their government bonds. The falling interest rates also lead to lower income for savers with ordinary savings or current accounts (see Figure 5). In Germany in particular, nominal interest rates on savings deposits have fallen significantly.

Figure 5
Nominal savings rates1 in the euro area

1 Savings deposits with an agreed term of up to one year.

Source: Deutsche Bundesbank.

Indeed, the low interest rates mean that it is currently more difficult for savers to receive their assets in real terms, as the interest rates for investments are currently (just) below the inflation-related depreciation of assets. The critics of the low interest rate policy of the European Central Bank (ECB) who point this out overlook the fact that such negative real interest rates are by no means unusual in historical comparison (see Figure 6); This is also pointed out by the Deutsche Bundesbank.3 Of course, it is primarily thanks to the low inflation rates that, despite the meager nominal interest rate on savings deposits, the real interest rate is historically not particularly low.

Figure 6
Real savings interest in Germany

Average interest rate for newly concluded household deposit contracts with up to three months' notice, deflated with the consumer price index.

Source: Deutsche Bundesbank; Calculations by DIW.

In this sense, the development is problematic at most for those who want to invest larger amounts of money at fixed interest rates over a longer period of time under the current conditions and cannot switch to alternative forms of investment with flexible returns. Difficulties arise from the current low interest rate environment for life insurance companies, which under the current circumstances can hardly generate the promised nominal guaranteed yields. For many other economic actors in Germany, including in particular many companies that can take out loans on favorable terms because of the low interest rates in order to finance investments, but also for those households that take out a loan to buy or build real estate, for example the low interest rate environment, on the other hand, is a relief.

Given the economic situation, monetary policy is not unusually expansionary

Criticism of the low interest rate policy is wrong because the ECB policy has to be based on the economic situation in the entire monetary union. It is completely normal for a heterogeneous currency area that monetary policy is not optimally aligned from the perspective of individual regions or countries. In this sense, the ECB is confronted with the classic problem of monetary integration, as formulated, for example, in the framework of the theory of optimal currency areas4. According to this, the central bank with its traditional instruments and in particular the interest rate policy has no way of pursuing a monetary policy adapted to the individual regional economic conditions, but rather has to choose a policy that is appropriate to the conditions prevailing in the monetary union as a whole. Criticism of the ECB based solely on the economic situation in Germany cannot therefore be appropriate.

In any case, it would not do justice to the economic situation in Germany to increase interest rates at this point in time. The German economy currently still has underutilized capacities; 5 the fact that the economic development has slowed down significantly since the second quarter does not suggest that the output gap will close in the near future. Against this background, it cannot be assumed that the inflation rate in Germany, which was only 0.8% in August, will rise noticeably. This is therefore unlikely to have a negative impact on real interest rates.

This is all the more true for the euro area as a whole: the inflation rate in the monetary union has for several years been well below the target defined by the ECB as price stability of below, but close to, 2%; in August it fell to 0.3%. In the crisis countries in particular, capacity utilization is low and investment activity is extremely weak. A more restrictive monetary policy is likely to complicate the gradual recovery process that is emerging in some of the economies - notably in Spain and Portugal - and for an additional one in those countries that continue to grapple with the consequences of structural problems - particularly France and Italy The already weak economy. While an expansionary monetary policy should not be a substitute for solving these structural problems, from a macroeconomic perspective, even in the longer term, there is nothing to suggest that the inflation target is expected to be exceeded under the given framework conditions. Rather, the danger cannot be dismissed out of hand that price dynamics in the euro area will become even less with a more restrictive monetary policy and that deflation risks will materialize

Despite the expansionary policy, the real economy is hardly recovering

The low inflation rates are already weighing on the economic recovery in the monetary union, as they are making it more difficult for households, companies and the state to reduce their debts. Low rates of price increase or even a decline in prices dampen tax revenues and make it even more difficult to reduce public debt, so that consolidation must be increased through public expenditure. After the bursting of the financial market and real estate bubbles in some of the crisis countries of the monetary union - namely in Spain and Ireland - private economic actors were confronted with the fact that the value of their assets had fallen significantly and their (net) debt had risen sharply. Because of the low inflation rates or even deflation, there was hardly any real relief in private debt either. As a consequence, households have severely restricted their consumer demand and companies have restricted their investment activity.

This phenomenon is not limited to the euro area. Rather, such “balance sheet recessions” were and are to be found for most economies, in which the bursting of financial or real estate market bubbles in recent years led to a devaluation of assets and, as a result, to high savings or low credit demand which in itself has led to falling interest rates. The low interest rate policy with which the central banks reacted to the crisis around the world put interest rates under additional pressure. The effect of this policy on real interest rates is limited because of the sharp drop in inflation rates - and the binding zero interest rate limit - and the expansionary impetus that comes from monetary policy is low. As a result, the recovery from the recession is taking place extremely slowly, with many economists expecting secular stagnation8 with long-term low growth and pronounced weakness in the labor market.

Correspondingly, the economic recovery in the euro area remains extremely hesitant. In some crisis countries, economic development has bottomed out and a gradual upward trend is emerging. However, most of the member states of the monetary union are far from the production and employment levels before the recession (see Figure 7).

Figure 7
Real gross domestic product in the euro area
Index, Q1 2008 = 100, last observation: Q2 2014

Now it cannot be denied that the decline in private and public spending in the crisis countries of the euro area should be seen as a correction of the orientation of the economies affected, which was absolutely necessary as the previous growth model - based, for example, on an excessive Construction activity or high public spending - has proven unsustainable. Now that this correction process seems to be gradually coming to an end, at least in some countries, economic actors are required to build new and hopefully sustainable economic structures. A more restrictive monetary policy is likely to be a burden in this process, as the investment activity required to build up new capacities, for example in the export industry, will be dampened.

Keep an eye on risks

The risks of the expansionary monetary policy are considerable. In the current environment, there is no guarantee that the investments stimulated by the low interest rates will actually flow into productive use that will sustainably strengthen growth. The sharply rising valuations on the real estate, bond and stock markets are probably rightly associated with the loose monetary policy.9 It cannot be ruled out that capital misallocations will occur again due to the monetary framework in the euro area and globally, which are accompanied by stronger growth in the short term, but this overheating will only dissipate after accepting serious upheavals in the markets. ECB President Draghi rightly points out that macroprudential regulation is primarily responsible for financial market stability and that the primary goal of the central bank is clearly related to price stability.10 However, monetary policy remains responsible for building financial imbalances, because when interest rates are low, economic agents have an additional incentive - also because certain nominal return targets are contractually agreed - to invest in riskier projects. 11


The criticism of the European Central Bank's low interest rate policy, which has recently been widely voiced, particularly in Germany, is inappropriate. Adjusted for price increases, interest rates are currently not unusually low, especially since - also in Germany - the inflation rate is extremely low. For the monetary union as a whole, there is a persistent breach of the goal of price stability, which the ECB considers to have been achieved at an inflation rate below, but close to, 2%. The economic development does not suggest that there will be a sharp rise in inflation rates, neither for the euro area nor for the German economy. Against this background, the ECB would do well to maintain its currently very expansionary course. The fact that such a policy has redistributive effects - from savers to debtors, from households to governments - is not to be blamed for; Redistributive effects are an essential feature of economic policy decisions and not an obstacle. Accusing the ECB of a lack of legitimacy in this context is misleading, because the primary goal of price stability, which has been assigned to the central bank by legitimate decision-makers, speaks in the current situation in favor of maintaining the expansionary policy.

It is true that the ECB should keep an eye on the risks of its policy, such as those particularly evident in overheating phenomena on the financial markets. However, other political actors are called upon to shape the framework conditions for the financial markets in such a way that the risk of new financial market imbalances remains as low as possible. European economic policy also has some catching up to do in this regard. The implementation of macroprudential measures has progressed rather slowly so far and the close link between private and public debt, which has accelerated the spread of the crisis in the euro area, has still not been broken

In any case, European economic policy - both at the national level and in Brussels - should not assume that the European Central Bank can solve the (current and future) difficulties of monetary union on its own. An expansionary monetary policy cannot be a substitute for solving structural problems, but at most serves to facilitate their solution.13 Furthermore, it is above all other actors who must ensure that the monetary union opens up viable growth opportunities again. First and foremost, work should be done to ensure that private investment activity recovers from the weakness in which it has been in many places for over a decade, and in some crisis countries for at least a few years. To this end, the establishment of a temporary investment fund should be considered in order to supplement the bank lending, which is currently still hampered by a high level of uncertainty. However, it is also important to improve the structural conditions for investments in Europe, for example through an efficient competition policy and an investment-friendly tax system.14 As long as there is little demand for capital from (private) creditors for investment purposes, interest rates will rise only slightly. It is inappropriate to criticize the European Central Bank for living up to its mandate.

  • 1 On the consequences of the low interest rate policy for public finances see also M. Kokert, D. Schäfer, A. Stephan: Low key interest rate: A chance in the euro debt crisis, in: DIW weekly report, no. 7/2014.
  • 2 Welt Online: Germany saves 120 billion through low interest rates, August 10, 2014, http://www.welt.de/wirtschaft/article131059965/Deutschland-spart-durch-Niedrigzins-120-Millionen.html.
  • 3 Deutsche Bundesbank: Negative real interest rates on deposits are not a new phenomenon, Frankfurt, June 27, 2014, http://www.bundesbank.de/Redaktion/DE/Themen/2014/2014_06_27_einlageverzinsung_in_deutschland.html.
  • 4 See groundbreaking R. Mundell: A Theory of Optimum Currency Areas, in: American Economic Review, 51st vol. (1961), no. 4, pp. 657-665.
  • 5 F. Fichtner et al .: Summer Baseline 2014, in: DIW weekly report, No. 25/2014.
  • 6 Cf. also K. Bernoth, M. Fratzscher, P. König: Risks of weak price development, in: DIW weekly report, No. 12/2014.
  • 7 R. C. Koo: The World in Balance Sheet Recession: Causes, Cure and Politics, Real-world Economics Review, 2011, H. 58, http://www.paecon.net/PAEReview/issue58/Koo58.pdf.
  • 8 See for an overview C. Teulings, R. Baldwin: Introduction, in: C. Teulings, R. Baldwin (Ed.): Secular Stagnation: Facts, Causes and Cures, A VoxEU.org eBook, CEPR Press, 2014, Pp. 1-23.