Speech Low Interest Rate Environments and Risk
Head of Economic Research
Paul Woolley Centre for the Study of Capital Market Dysfunctionality Conference
In recent years there has been an increasing concern globally that extended periods of low interest rates pose a problem for economic and financial stability because they encourage excessive risk taking. The immediate cause of the concern seems to have been the experience of the global financial crisis. The standard narrative goes that low interest rates through the 2000s encouraged a build-up of risk taking that caused the global financial crisis. People then look at current interest rates and worry that we might be experiencing the very same dynamic; that history might be repeating itself.
This concern has shown up in various places and in various forms. In the finance literature, it has been observed that low interest rates might spur excessive risk taking. For example, Raghuram Rajan, now Governor of the Reserve Bank of India, suggested that investment managers have incentives to take risks that are hidden from investors in pursuit of higher yields – the so-called ‘search for yield’. In a slightly different area, John Taylor has argued that by keeping interest rates too low between 2003 and 2005 the Fed brought about a search for yield, contributed to the housing bubble and, thus, was a key factor in the financial crisis. More recently, there is the concern associated with secular stagnation. In an environment where there is a chronic shortfall in demand, even zero nominal interest rates may not be sufficient to restore equilibrium. And, as Larry Summers has emphasised, this environment may be conducive to ‘bubbly’ asset prices as real interest rates lower than the growth rate can encourage the formation of financial bubbles.
So, what is one to make of these concerns? Are low interest rate environments inherently unstable – promoting financial and macroeconomic instability wherever they go? I don't think so. But, before getting to that conclusion, it is useful to first step through some of the arguments that have been made to clarify why we might be concerned before turning to the reasons I am more sceptical.
It is important to make it clear, at this point, that these are my personal views and that what I am saying has no particular implications for the stance of monetary policy in Australia. My talk contains no hidden messages about the next move in interest rates. I'm focused on an issue that has been of concern globally and talk about it very much in that context. Any implications for monetary policy decisions in Australia are coincidental.
Search for yield, secular stagnation and the Taylor Rule
So, after that little diversion, I'd like to take a little time to flesh out the three arguments I mentioned above: the search for yield, the arguments of John Taylor, and secular stagnation.
Search for yield
Search for yield shouldn't be a bad thing. Indeed, this is how the system should work. Investors searching for yield is how funds are allocated to their most productive use. But people who use the term ‘search for yield’ have in mind a less efficient state of affairs. The ‘search for yield’ argument is, as set out by Rajan, an argument that nominal benchmarks are embedded in many financial market decisions. For example, he argued, that life insurance companies have written contracts with minimum guaranteed nominal returns in them; that funds managers have mandates with nominal targets. When inflation or real interest rates fall, it gets harder to reach those nominal targets and, instead of choosing a more sensible benchmark, they take on more risk. An alternative suggestion is that markets are beset by serious principal-agent problems. That is, because the compensation contracts of asset managers reward returns and don't penalise risk, particularly infrequently observed tail risk, they have an incentive to take on excessive risk. In a similar vein, Jeremy Stein has introduced the idea of ‘yield oriented’ investors, possibly created by quirks in accounting rules. That is, investors who care only about current bond yields and not their mark-to-market price.
The evidence, however, is quite weak and mostly anecdotal. Stein presents some evidence that there might be ‘yield oriented’ investors in the market – but it is fairly circumstantial. There is better evidence of increased risk-taking by banks in low interest-rate environments. Using a unique database of loan applications from Spain between 2002 and 2009, Gabriel Jiminez and his co-authors neatly identify a bank risk-taking channel of effect for monetary policy. In Canada, Gungor and Sierra identify a similar effect for fixed-income mutual funds. They find expansionary monetary policy induces risk-taking behaviour by mutual funds.
The Taylor Rule
John Taylor's argument, at least insofar as it relates to the causes of the financial crisis, is relatively straightforward. Interest rates lower than was consistent with historical patterns (that is, below the level predicted by the Taylor Rule) stimulated the US economy excessively and simultaneously contributed to a search for yield. That is, interest rates were set inappropriately low. When combined with lax regulatory policy, this contributed to a strong but fragile US economy – most notably evident in the unsustainable growth of house prices. In this respect, Taylor is in general agreement with many commentators although there is an important difference of emphasis. Ben Bernanke, for example, emphasises lax regulatory policy while acknowledging only the possibility of a secondary, or indirect, role for interest rates. A similar argument has been made for other countries, such as Spain and Ireland, where inappropriately low interest rates – set, as they were, by the European Central Bank (ECB) for the eurozone – are blamed for their housing bubbles and subsequent financial distress.
Turning to secular stagnation, the basic argument is that there is an excess of global savings relative to the available productive investments. This excess of savings drives down the interest rate. However, because of a combination of structurally lower equilibrium interest rates and the zero lower bound, it is not possible for the interest rate to fall far enough to equalise demand and supply. As a result there are excess funds looking for a home. Larry Summers has argued that this makes economies inherently bubbly. In a world where there are few productive investment opportunities, reflecting depressed economic conditions, asset purchases look particularly attractive. And this can contribute to a self-reinforcing cycle as the resulting asset-price increases become justification for greater investments in assets – ‘rational’ bubbles may be prone to forming. Although, it is important to note that the possibility of secular stagnation is not an argument against lowering interest rates. In fact, it is an argument for doing more, and more aggressively, because the fundamental problem is the gap between demand for investment opportunities and their supply – raising rates would only widen this gap.
The suggestion that interest rates may be structurally lower now is consistent with work showing that real interest rates have been on a downward trend for some time and that this is unlikely to be reversed soon. Ricardo Caballero and Emmanuel Farhi expand on the ideas of Larry Summers by showing how the world economy may find itself in a ‘safety-trap’ where there is a chronic (rather than acute) shortage of safe assets. They argue that in this environment, financial bubbles may crowd out other risky (but productive) assets leaving wealth and demand unchanged, but growth lower. That is, while asset investments (such as property) may temporarily provide an outlet for excess savings, they don't solve the underlying problem.
These arguments are all certainly grounds for concern. But so far I've only really considered one side of the story. And I want to now turn to arguments against the position that low interest-rate environments are inherently unstable – and make the point that the evidence I discussed above, suggestive as it is, is merely suggestive and not conclusive.
Sometimes risk-taking is the point
The fact that lower interest rates induce risk-taking is not, of itself, reason to avoid lowering interest rates. Indeed, that's one of the ways lower interest rates stimulate economic activity. They do this by encouraging the granting of loans to entrepreneurs who couldn't previously get funding because the returns were too uncertain or too low. And none of the papers I've read can separate appropriate or desired risk taking from inappropriate and undesired risk taking. Low interest rates might induce a ‘search for yield’, but the evidence to date can't separate this from ordinary and desired risk-taking behaviour.
Another concern with the very neat results from Jiminez on bank risk taking is that they come from a country where policy was not being set appropriately for Spanish economic conditions. Policy was being set in Frankfurt for the eurozone. While this is great for econometric identification, it is less useful for thinking about the effects of low interest rates in countries where it is being set appropriately for domestic conditions. In that respect, the experience of the mid-2000s generally, when economic conditions were buoyant and interest rates were, with hindsight, generally too low, may not be the best guide to periods when economic conditions are anaemic and interest rates are appropriately low.
Another aspect to the discussion is that, in a world of lower real interest rates, asset prices may be higher for fundamental reasons. If the future is discounted less, as it is when interest rates are lower, present values, as embodied in asset prices, are higher. Thus, the observation that asset prices are higher in a world of low interest rates is not, immediately, proof that asset prices are bubbly and prone to destabilising volatility.
So, while there are grounds to be concerned, there are also reasons to think that there may be an excessive degree of sensitivity about anything that looks remotely like the financial crisis. Ultimately though, this is an empirical question. As noted above, a certain amount of risk taking is desired. It is only ‘too much’ risk taking that is a problem. So, how might we assess whether low interest rates are consistently or predictably associated with excessive risk taking? The argument to date seems to be as simple as an extended period of low interest rates caused the global financial crisis (GFC), therefore we should avoid low interest rates. But there is a much broader body of research on the GFC and what causes financial crises in general. So what does it say?
While there are many such studies, I found a recent ECB working paper by Jan Babecký and others quite interesting. They looked at a large set of financial crises in developed economies to work out which are the best early warning indicators. They found that the most robust early warning indicator of banking crisis onset, that is, the one that appears most consistently in predictive models, is rising domestic private credit. At long horizons, increasing household debt and decreasing corporate interest rate spreads also show up as indicators. At shorter horizons, rising money market rates make an appearance as a late-warning indicator. All of which they interpret as evidence that banking crises occur during expansion phases. Low interest rates, however, do not show up as a reliable indicator. And this lack of significance is fairly consistent across studies.
So, once again, one must ask, why are people so concerned about low interest rates? An alternative concern, once again rooted in the most recent experience, would seem to be that low interest rates are implicated in the formation of property and financial bubbles. That is, people think that low interest rates are associated with greater asset price, and hence financial, volatility. But, looking at the breadth of history suggests there is no particular link between interest rates and financial or asset price instability.
For example, current low government bond yields have led to a lot of talk about a bond bubble. But this isn't the first time interest rates have been so low. Graph 1 shows the US 10-year bond yield from 1950 along with the rolling two-year standard deviation of the price. What should be clear is that, despite a wide variation in yields and regulatory and financial environments, there is no correlation between the level of yields and price volatility. Low bond yields are not obviously inherently volatile.
What about historical bubbles? Were they generally associated with low interest rates? I looked at a few Australian examples in a paper I wrote a decade ago and, while credit and leverage were present in all of them, low interest rates were not. For example, the 1987 stock market bubble and subsequent commercial property bubble occurred in an environment of high interest rates – rates were above 10 percent for almost all of the 1980s and frequently approached 20 percent. Furthermore, there are many periods when interest rates have been low and excessive risk taking has not occurred. Indeed, low interest rates have been a more common feature of the financial system over time than high interest rates – which are very much an aberration related to the 1970s and their aftermath. And it is to the longer history of interest rates that I want to now turn to get some additional perspective.
It is only in the most recent crisis that low interest rates have been seen as the problem
Nominal interest rates have been low for much of the past 400 years. Looking at UK monetary policy interest rates (which I look at because the data is available, and the UK was very much the centre of Australia's financial world for much of our history) one can see how much of an aberration the 1970s were (Graph 2). From around 1700 they spent a long time at 5 per cent – the sort of level that prevailed during the build-up to the GFC. In the 50 years prior to WWI they ranged between 2 and 6 per cent, with them at 2 per cent much of that time. During the Great Depression and WWII they were similarly low, stuck at 2 per cent until the 1950s.
And yet, despite interest rate settings and circumstances somewhat similar to today, the aftermath of the Great Depression did not lead to another financial crisis. Rates were low, but appropriately so given the weak underlying growth. Moving on to more recent times, and turning to Australia now that data are available (Graph 3), we see that, as with most other countries, nominal interest rates in Australia were low and stable through the 40s, 50s and 60s and only really took off in 1973.
And yet, just like the post-Depression 1930s, the 1950s and 1960s are not particularly associated with excessive risk taking. A large part of the explanation here is the policy of ‘financial repression’ employed in the post-war years. Quantity and other controls were used to direct savings towards government bonds at artificially low rates. High-risk commercial ventures could not get access to credit because of controls on the quantity of credit rather than the level of the interest rate. Banks rationed credit and only offered it to the highest-quality borrowers. So, while underlying growth was very strong, de facto prudential standards were very tight.
Even after deregulation, however, high nominal lending rates in a high inflation environment continued to act as a de facto prudential control. People had to demonstrate an ability to repay the loan and, with high nominal interest rates leading to high loan repayments, that was a binding constraint. Loan servicing became much easier after the first few years because of high wage inflation. So, provided banks ensured people could cover loan repayments in the first few years, inflation took care of the rest.
This short tour of history should highlight how abnormal the pre-crisis period was. It is really only when the combination of low nominal interest rates, solid growth and a deregulated banking system arose that the finger of blame started pointing towards interest rates. But, even then, there were differences across countries. While most countries had low interest rates, prudential standards varied. While some countries managed the environment well, this was clearly not universal. Thus, one can conclude that even in buoyant low interest rate environments, appropriately calibrated prudential policy can help to restrain risk taking by financial institutions.
Synthesis and conclusion
So what is one to make of this? As my discussion above should make clear, I don't think low interest rates, on their own, are inherently risky or destabilising. Rather, inappropriately low interest rates – that is, low interest rates during times of strong economic growth – combined with inadequate prudential supervision can contribute to a build-up of risk that is ultimately destabilising. But even if one accepts that low interest rates can contribute to the problem, low interest rates aren't the indicator one should be looking at. As reflected in the results of the early-warning literature, and also the fact that excessive leverage is commonly associated with financial booms and busts, some sort of credit measure is better than looking at interest rate levels. Credit tends to reflect a combination of the relative speed of growth, the tightness of prudential controls and the tightness of monetary policy, while interest rates alone do a poor job. But even credit is but one indicator of possible problems, so this is not an argument that we should just look at credit instead.
In sum, in 2007 we experienced a combination of factors that each contributed to the financial crisis. The world economy was growing strongly, but contained inflation led many central banks to keep interest rates low. In some economies prudential regulation was clearly inadequate to contain a deregulated banking sector. Together, these contributed to a highly leveraged financial sector. And the rest, as they say, is history.
This of course leads to another observation – in many advanced economies with low interest rates these other conditions are not apparent at the moment. Economic growth is weak, credit growth is generally low, there are many people paying down debt and not many investing – we could probably do with a bit more entrepreneurial risk-taking. (Although, to be clear, we could do with less leveraged speculation.) Furthermore, chastened by the experience of the financial crisis, prudential regulators the world over are raising standards. Here in Australia, a few months ago the Australian Prudential Regulation Authority (APRA) announced that it would be increasing capital charges on some mortgage lending and the major banks have increased their investor loan interest rates to slow growth in line with APRA measures. So, while it never pays to be complacent, there are few early-warning indicators for a financial crisis despite the prevalence of low nominal interest rates. In any case, low interest rates are a poor indicator of future problems and, given currently weak global growth, entirely appropriate. Thus, I think, concern over the current low levels of interest rates expressed by John Taylor and those who worry about the search for yield are probably overdone.
Now, there will undoubtedly be problems in the future. But I suspect they will, as has happened so many times through history, come from an unexpected direction. So rather than fighting the last battle again, it is important to look ahead and try to discover the seeds of the next recession or crisis before it happens. In that respect, I imagine that many of you here at this conference have something to contribute. So, after I have spent the last half hour suggesting where not to look, maybe you can suggest where we should look instead.
Rajan (2006). 
See, for example, John Taylor (2015). 
Summers (2014). 
Hansen and Stein (2012), Stein (2013). 
Jiminez et al (2014). 
Gungor and Sierra (2014). 
Bernanke (2010) agrees there may be some truth to the contention that monetary policy, by contributing to the Great Moderation, may have induced a complacency in investors that led to inappropriate risk taking. But he doesn't agree with Taylor's argument that low interest rates per se caused the problem – or at least that the Fed had any choice in the matter. 
Summers (2014). 
Laubach and Williams (2003), IMF (2014). 
Caballero and Farhi (2014). 
Babecký et al (2012). 
Simon (2003). 
Babecký J, T Havránek, J Matějů, M Rusnák, K Šmídková and B Vašíče (2012), ‘Banking, Debt, and Currency Crises: Early Warning Indicators for Developed Countries’, European Central Bank Working Paper No. 1485.
Bernanke BS (2010), ‘Causes of the Recent Financial and Economic Crisis’, Statement before the Financial Crisis Inquiry Commission ‘Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis’, Washington DC, 2 September.
Caballero RJ and E Farhi (2014), ‘The Safety Trap’, NBER Working Paper No 19927.
Gungor S and J Sierra (2014), ‘Search-For-Yield in Canadian Fixed-Income Mutual Funds and Monetary Policy’, Bank of Canada Working Paper No 2014-3.
Hanson SG and JC Stein (2012), ‘Monetary Policy and Long-Term Real Rates’, Board of Governors of the Federal Reserve System Finance and Economics Discussion Series No 2012-46.
IMF (International Monetary Fund) (2014), ‘Perspectives on Global Real Interest Rates’, World Economic Outlook: Recovery Strengthens, Remains Uneven, World Economic and Financial Surveys, IMF, Washington DC, pp 81–112.
Jiménez G, S Ongena, J-L Peydró and J Saurina (2014), ‘Hazardous Times for Monetary Policy: What Do Twenty-Three Million Bank Loans Say about the Effects of Monetary Policy on Credit Risk-Taking?’, Econometrica, 82(2), pp 463–505.
Laubach T and JC Williams (2003) ‘Measuring the Natural Rate of Interest’, The Review of Economics and Statistics, 85(4), pp 1063–1070.
Rajan RG (2006), ‘Has Finance Made the World Riskier?’, European Financial Management, 12(4), pp 499–533.
Simon J (2003), ‘Three Australian Asset-Price Bubbles’ in A Richards and T Robinson (eds), Asset Prices and Monetary Policy, Proceedings of a Conference, Reserve Bank of Australia, Sydney, pp 8–41.
Stein JC (2013), ‘Overheating in Credit Markets: Origins, Measurement, and Policy Responses’, Breakfast Keynote Address at ‘Restoring Household Financial Stability after the Great Recession: Why Household Balance Sheets Matter’, Research Symposium sponsored by the Federal Reserve Bank of St. Louis and the Center for Social Development at Washington University in St. Louis, St. Louis, 5–7 February.
Summers LH (2014), ‘U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound’ Business Economics, 49(2), pp 65–73.
Taylor JB (2015), ‘A Monetary Policy for the Future’, Panel Remarks for Session 3: Monetary Policy in the Future, IMF Conference on ‘Rethinking Macro Policy III: Progress or Confusion?’, Washington DC, 15–16 April.