When Will Low Interest Rates End?

A recent piece in the Financial Post titled “How many times can economists cry wolf about interest rates” caught my interest because I – like many economists in Canada – have been expecting interest rates to eventually start to rise and yet they do not.  So when will Canadian interest rates start to go up?  My knowledge of money and banking and monetary economics is pretty rudimentary but I'm feeling adventurous in the New Year.

At its most basic level the demand for and supply of money sets the interest rate.  If money supply shifts right faster than money demand, then interest rates will fall.  So assuming money demand is strongly driven by growing transactions fueled by rising output, I suppose one answer is that rates will rise when the growth rate of the money supply is curtailed so that it grows less quickly relative to GDP.

Take a look at Figure 1.  I used the monthly estimates of M2 for Canada constructed by Cherie Metcalf, Angela Redish and Ron Shearer for the period 1871 to 1967 and combined them with the monthly estimates of M2 for 1968 to the present from Statistics Canada (v41552796). I took the monthly average each year for the period 1871 to 2013 and used this annual average to estimate the annual growth rate for M2. Over the entire period 1871 to 2013, the average annual growth rate of M2 was 7.2 percent.  While growth in 2009 during the financial crisis was 13.52 percent, it has since ranged from 4.95 to 6.60 percent. This suggests that the recent growth rate of M2 has not been that high by historical standards.

However, money supply growth needs to be considered in the context of the growth of the economy and money demand.  Figure 2 presents a more interesting picture by taking the ratio of M2 to GDP for the period 1871 to 2013.  From a ratio of just under 0.2 in 1871, the M2 to GDP ratio has grown over time.  Recent years have seen it grow to the highest it has ever been.  Of course, the period from 1870 to 1930 reflects the growth and development of the modern Canadian financial intermediary sector and monetary sector and the rise in the ratio reflects this.  However, the period since 1935 represents the “modern Canadian banking era” in that the Bank of Canada has been in existence during that period. 

 

 

Figure 3 presents a graph of the trend setting Bank of Canada interest rate and it shows a hump shaped pattern with the lowest interest rates in the period from 1935 to the mid 1950s and since 2009 and the highest rates in the period from the mid 1970s to the early 1990s. On the other hand, since the Second World War, the M2/GDP ratio has shown an approximately u-shaped pattern with lowest M2/GDP ratios in the mid to late 1960s.  If the two are juxtaposed as in Figure 3a and taking into account that there is probably a lag between a drop in M2/GDP and the subsequent rise in interest rates, it appears that the peak in interest rates occurs after the low point in the m2/GDP ratio in the late 1960s. If you take the first differences of the M2/GDP ratio and the Bank of Canada rate over the period 1935 to 2013 and plot them against each other (as in Figure 4) and fit a linear trend, you do get a slight inverse relationship.  That is, a higher money supply to GDP ratio is correlated with lower interest rates.  However, I admit this is a pretty noisy picture.  Moreover, this discussion focuses just on Canada and international economic and monetary conditions play a role in the Canadian economy. It would be interesting to see how the performance of Canada’s M2 to GDP ratio over time compares to other countries.

 

 

We have been expecting interest rates to rise for several years now because GDP has recovered somewhat from the 2009 financial crisis and the Canadian economy is growing.  As a result, one might expect a growing demand for money and credit to fuel rising interest rates.  However, money supply – as measured in this case by M2 - is still growing faster than GDP.  I think we will see interest rates start to increase provided first that GDP continues to expand and then the M2/GDP ratio starts to drop.  However, its not enough that this happens just in Canada – it would also need to happen on a global scale. I don’t think that is going to happen anytime soon. For example, look at Japan.

 

 

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Comments

[Yancey Ward]

When will Japanese rates rise?

[Frank Restly]

Nick,

"At its most basic level the demand for and supply of money sets the interest rate. If money supply shifts right faster than money demand, then interest rates will fall."

The supply / demand for bonds AND the supply / demand for money sets the interest rate. If the money supply shifts right faster than money demand and the bond supply either stays the same or shifts left faster than bond demand then interest rates will fall.

However, if the money supply shifts right faster than money demand but the bond supply shifts right against bond demand more quickly then interest rates could rise.

This could happen if a significant portion of equity was converted to debt.

[Patrick]

Frank, check the author again.

[Frank Restly]

Eek,

Sorry about that Livio.

[Livio Di Matteo]

No problem Frank. I'm flattered you thought it was Nick!

[Determinant]

Referring to Min's post in Nick's thread from a few days ago on Taboos, the most advanced world economies are depressed. Depression is the word that dare not speak its name, but given how lacklustre this recovery has been, it fits. Rates will rise when the depression ends, and the depression hasn't ended.

It's feels like 1938 around here.

[Nick Rowe]

Tough question Livio.

Assuming the Bank of Canada doesn't do anything really stupid (I don't think it will):

The full ending of the recession and the return of inflationary pressures will be a necessary condition. The US economy seems to be strengthening. Japan too, and others. Eurozone and China are wild cards. That will help strengthen world demand and push up world interest rates.

But at the same time Canadian inflation is too low. The Bank raised interest rates too much and too soon.

It's unlikely, but I would not rule out the next change being a cut. Say 30% prob. Otherwise they will probably start raising in about a year. But that's a guess. Could be 6 months, could be 18 months, easily.

The big question is: will interest rates return to where they were before? I don't think they will. I think there's a secular change going on as well. "The economy needs a bubble"/secular stagnation sort of stuff. Due to historically unprecedented global demographics.

Just a guess. I will be wrong, as usual.

[Nick Rowe]

On the big question: that was real interest rates. There's a chance they will raise the inflation target, if the secular stagnation thing turns out to be right, to avoid the ZLB in future.

[Bob Smith]

"It's feels like 1938 around here"

So... go short on Germany?

[Lorenzo from Oz]

No Depression down here, and it so does not feel like 1938. It feels like the Great Moderation hasn't ended. But we are in a different place. (The moment when the capitalisation of Australian banks--a country with 23m pop--equalled the capitalisation of all banks in the Eurozone--333m pop--was a very strange moment conceptually, but it felt no different down here, of course.)

Of course, it all just gets waved away as "China + commodities", though how that explains no recession since 1991-92 I am not sure.

Having a central bank that (implicitly) pays attention to income expectations; nah, that can't be it. Nothing to see here but lots of commodities being sold to China, move along …

Not having a strict inflation targeting central bank; it's like being a silver standard country during the Great Depression.

[Nick Rowe]

Lorenzo: Suppose I were trying to attack the MM position on Australia. I would not say "China+commodities". I would say:

"Australia has a high natural rate of interest, for some unknown reason, so had high nominal interest rates during the great moderation. So when the crisis hit, the RBA was able to cut nominal interest rates a lot (and people could see that it could cut nominal interest rates a lot, if needed) and so the ZLB was never a binding constraint in Oz, so Oz escaped a recession."

But then there is New Zealand.

[stone]

Might Australia have higher interest rates because mining jobs can not be offshored? The iron ore is in Australia and has to be mined by Australians because of immigration laws so wages are high.
Perhaps if Australia had let in unlimited numbers of low wage guest workers from across the world to do the mining, then Australians would be on low wages and interest rates would be at the zero bound in Australia?

[Lorenzo from Oz]

NIck: Yes, there is New Zealand, indeed. And handwaving about a higher natural rate of interest is surely not a strong argument. (Though I suspect the RBA deliberately went for a somewhat higher inflation rate because of rigidities in the Oz labour market.) Lars Christensen's argument about the RBA having an export price norm is also fairly persuasive.

Stone: Mining is a pretty small proportion of Australian labour market. (In 2008-09, Mining employed 135,000 people in a labour force over over 11m and was 8% of GDP.) Australian mining is also very capital intensive, and not merely because wages are high. Australia is a relatively high importer of migrants (25% of residents were foreign born in 2007). No plausible level of migration intake would change that.

[stone]

Lorenzo, I'm really interested that you are saying that mining is not so important. In the UK we are told about truck drivers in Australia being paid multiples of what they are paid anywhere else and that that is all down to the mining boom.I googled and came to this Australian news item:
The Chinese workers on the Sino Iron project in the Pilbara are believed to be getting $70,000 to $80,000 for jobs for which Australian workers would be paid about $150,000.
It is the first investigation by the department into alleged underpayment at the site — despite repeated assurances by Canberra since September 2010 that any attempt to underpay foreign workers on the $5.4 billion project would be stamped out immediately.
Read more: http://www.smh.com.au/federal-politics/political-news/foreign-mine-workers-on-half-pay-20120528-1zffx.html#ixzz2pQX6G3vF

Even if only 1% of the workforce gets those big wages, doesn't that trickle out because they will pay more for services and such like? If there was no law about paying guest workers less than the Australian market rate then wouldn't those $150k wages be replaced by $15k wages and so everything else from house prices to piano lessons would become much cheaper? Currently don't Australian households build up debt to allow Australia to run a persistent current account deficit? Are you saying that those big mining wages are not underpinning Australia's ability to do that? Why otherwise would banks lend so much to Australian households rather than say households in Bangladesh?

[Lorenzo from Oz]

Stone: mining is the froth and bubble of the Australian economy. Sure, it drives a lot of the business cycle, but we have a pretty mild business cycle since 1992. And there are well-paid jobs in lots of other industries than mining, mining just has a high average income. Moreover, it has been Australian public policy to keep labour relatively scarce by restricting immigration for about 130 years, we just stopped using any racial criteria 40-50 years ago. Indeed, our migration policy makes labour a little less scarce than it might otherwise be.

Open slather is not going to happen. Even the guest worker program we have is controversial.

We have a high current account deficit because investment opportunities outweigh local saving--the normal state of affairs in Australia for the last 200 years or so. We having expensive housing because we adopted the British land use regulation model with comparatively high population growth -- restricted supply for housing land and high demand for housing will push up prices.

Until the recent commodities boom, our terms of trade had been trending down for decades, yet living standards continued to rise. There is a much bigger picture than just mining.

[stone]

Lorenzo, I am really fascinated by Australia because, if it isn't mining then your economy is a miracle.

On the one hand you are saying that restricted housebuilding and high immigration ensure a house price inflation that makes banks happy to lend to Australians willy nilly.

On the other hand you are saying that labour can command high wages because immigration is restricted. If the jobs are not underpinned by the mines, why is Australia sufficiently competative to keep the exchange rate from sliding?

Could any and every other country with an educated, peaceful population emulate Australia's system and attain an Australian standard of living similarly boosted by perpetual current account deficits? Much of the "investment opportunities" simply amount to lending mortgages to push up house prices don't they? In principle that could be done anywhere in the world. Presumably though banks trust that Australians will be able to command high enough wages to service those mortgages whilst elsewhere in the world, truck drivers dont get paid $100k per year so can't.

[Lorenzo from Oz]

Stone: Wages are a measure of relative scarcity v capital & land. Australia has a lot of capital and land but a relatively small population. We import capital (see Current Account Deficit) more than labour increases, so the tendency is for wage income to rise (and capital income). There is no mystery here.

People invest in Australia because it is a stable democracy with rule of law. Sure, mining tends to drive the exchange rate, but the exchange rate floats, so acts as a shock absorber. Yes, there is an element of "resource curse" driving up the exchange rate, but we have a range of export industries.

On housing, we have pretty strong bankruptcy laws. You cannot walk away from your mortgage. Though I am not a fan of how much lending goes into housing nor our perverse land rationing system. (I would much prefer the German system, since I don't think we are going to go Texan.)

The business cycle being mild is the largely the RBA (implicitly) playing attention to income expectations, since its target is an average of 2-3% inflation over the business cycle.

[stone]

Lorenzo, to me the ability to "import capital" is the great great mystery. What you describe is exactly as how I saw it. The only difference is that you don't see any mystery. I must admit, I am still not convinced that mining isn't underpining it all. Are you basically saying that the rule of law is all that it takes entice in capital to lend for fueling houseprice inflation in a self sustaining virtuous circle?
Latvia had a go at emulating the housing price inflation mediated road to prosperity and it blew up in their faces after a very short hopeful start. They had very creditor friendly laws that were enforced didn't they but the wages to service the mortgages didn't materialize. If you are saying that high mining wages don't underpin the Australian set up, then where did Latvia go wrong?

[Too Much Fed]

"My knowledge of money and banking and monetary economics is pretty rudimentary but I'm feeling adventurous in the New Year.

At its most basic level the demand for and supply of money sets the interest rate. If money supply shifts right faster than money demand, then interest rates will fall. So assuming money demand is strongly driven by growing transactions fueled by rising output, I suppose one answer is that rates will rise when the growth rate of the money supply is curtailed so that it grows less quickly relative to GDP."

How adventurous?

[Jason]

I find that the ratio of GDP to the monetary base (MB/NGDP) does a better job of giving that linear relationship between the ratio and short term interest rate than M2/NGDP ... I don't have the long run data for the base that you have for M2 however.

http://informationtransfereconomics.blogspot.com/2013/10/o-canada.html

[Too Much Fed]

"At its most basic level the demand for and supply of money sets the interest rate. If money supply shifts right faster than money demand, then interest rates will fall."

Can you expand on that? This is a better question than it sounds.

[Livio Di Matteo]

Too Much Fed:
As I mentioned at the outset of my piece, my knowledge of monetary theory is pretty basic - confined largely to whatever was covered in my macro courses years ago. As a result, I would consider a post on monetary matters fairly "adventurous" for me. The mental model was a simple money market with money and bonds with bonds having a return greater than zero and money having a return of zero. As well, you can use money in transactions but not bonds. The interest rate - which is essentially the interest rate on bonds would be on your vertical axis - while the nominal quantity of money would be on the horizontal axis. The demand for money is downward sloping and the supply of money a vertical line and their intersection generates the equilibrium interest rate. Shifts in the demand or supply of money would affect the interest rate. Changes in income can shift the demand for money. Monetary policy can shift the supply of money. How's that?

[ReturnFreeRisk]

Thanks to the Fed - the answer is NEVER

[Too Much Fed]

Livio said: "How's that?"

Do the bonds have different maturities?

Let's add a central bank that can set the risk-free overnight rate, the reserve requirement, and the capital requirement. Next, add a commercial bank.

Now have the central bank increase the supply of "money". What happens?

Now have the commercial bank increase the supply of "money". What happens?

[Livio Di Matteo]

Too Much Fed:
Well, I would put that under monetary policy.

[Too Much Fed]

In this model, increasing the supply of "money" shifts the vertical line to the right so that the "interest rate" falls, correct?

[Livio Di Matteo]

Too Much Fed:
Yes. Thus, monetary policy that increases the money supply would lower interest rates.

[Too Much Fed]

Here is where the "standard" model fails.

Case 1: Assume a 10% reserve requirement for demand deposits. Have the fed do QE and buy $1000 of bonds from an individual at a commercial bank.

The fed gets the bonds. The individual gets $1,000 in demand deposits. The commercial bank gets $1,000 in central bank reserves at its account at the fed. $100 of the central bank reserves become required. There are $900 in excess central bank reserves. The fed funds rate falls.

Case 2: Assume a 10% reserve requirement for demand deposits. Have the commercial bank do "QE" and buy $1000 of bonds from an individual at the commercial bank.

The commercial bank gets the bonds. The individual gets $1,000 in demand deposits. The commercial bank needs $100 in currency or central bank reserves to meet the reserve requirement. That shortage causes the fed funds rate to rise.

Notice the difference. With case 1, more "money" leads to a lower fed funds rate. With case 2, more "money" leads to a higher fed funds rate. I have ignored the capital requirement.

Lastly and as long as currency and demand deposits are 1 to 1 convertible, I consider demand deposits to be "money". They are medium of account, medium of exchange, and store of value.

[Frank Restly]

Too Much Fed,

In case 1, the supply of debt / bonds does not change. In case 2, the supply of debt / bonds rises - bank borrows money from central bank to meet reserve requirement.

In case 1, the demand for debt / bonds increases - central bank becomes a net buyer of bonds. In case 2, the demand for debt / bonds increases - central bank becomes a net buyer of bank debt.

Case 2 would only lead to a higher fed funds rate if the central bank was offering fed funds at a interest rate positively correlated with demand for those funds. They might not. I could conceive of a situation where the central bank was offering fed funds at a rate of return totally uncorrelated with the demand for those funds.

[Too Much Fed]

Frank, let's assume $1,000 of existing gov't bonds were purchased in both cases.

"In case 1, the supply of debt / bonds does not change. In case 2, the supply of debt / bonds rises - bank borrows money from central bank to meet reserve requirement."

I'm not sure I would call case 2 borrowing from the central bank. It seems more like an asset swap. Swap $100 in gov't bonds for $100 in central bank reserves. Reserve requirement met.

"In case 1, the demand for debt / bonds increases - central bank becomes a net buyer of bonds. In case 2, the demand for debt / bonds increases - central bank becomes a net buyer of bank debt."

Even if the commercial bank bought bonds that were not from the gov't, I still think the fed would want to swap $100 in gov't bonds and $100 in central bank reserves for case 2 to meet the reserve requirement.

"Case 2 would only lead to a higher fed funds rate if the central bank was offering fed funds at a interest rate positively correlated with demand for those funds. They might not. I could conceive of a situation where the central bank was offering fed funds at a rate of return totally uncorrelated with the demand for those funds."

If the fed was targeting the fed funds rate, it would notice the upward pressure and react to maintain the target.

[Jason]

An update on my comment above about a model basis for using the ratio M2/GDP:

http://informationtransfereconomics.blogspot.com/2014/01/worthwhile-canadian-interest-rate.html

[NoniMausa]

I have wondered for a couple of years about the guys crying wolf about interest rates. It seems to me that lending is not your usual sales structure where one party has a loaf of bread and the other has a loaf's worth of money. Rather, a lending relationship requires that both parties have credit offset in time.

So, the lender needs currency with its value protected into the future, by federal agencies supporting it against various threats ( financial regulation, counterfeiting, and so on. The borrower offers the promise of future earning power. Some of the surety of that future earning power depends on the individual, but less than you would expect. Much of it depends on the future economy, again protected or structured by the government, via wage and price regulation, labour laws, military defence, tariffs and so on.

If both parties are confident that the value of currency and the prospects of borrowers are protected, then I could see interest rates rising. Absent those assurances, why would lenders risk their capital, or sober borrowers take on such risk?

Rather, one would expect to see higher interest rates in only two scenarios -- in cases where the borrower is extraordinarily secure, and could justify large and more long term loans, or in cases where the borrower is extraordinarily insecure, desperate enough that they would undertake short term loans at very high interest rates. Another form of hollowing out.

In the former case, interest rates really wouldn't rise much at all, seeing as how lenders are swimming in cash. In the latter case -- well, how long has "payday loan" been a common financial instrument? Since the early to mid nineties, Wikipedia says.

So, it appears that for some borrowers, the effective interest rate is not "going to" rise, it has already risen. For large, secure borrowers, there's really no reason it should ever rise. Or so it appears to me.

Noni