From The Conversation

This post authored by Rodney Maddock, Monash University

When a central bank lifts interest rate targets by 0.5% it expects households and firms to respond. In a crisis, the official target may fall by 3% in order to shock the economy into a positive response. These movements of interest rates by the central bank are an important tool of macroeconomic adjustment.

They are also relative to the longer term, or normal rate of interest in the economy. What is interesting now is that rates have been low for quite a long time suggesting the natural rate of interest in the economy has fallen permanently.

A recent research paper from the Bank of England suggests that the global neutral interest rate may settle at or below 1%. To put this in context, the paper suggests that rate was around 5.5% in the 1980s (yes, that is real, so adjusted for inflation).

Central banks will get into a tizz about this because it gives them less room to cut rates to stimulate the economy. It gives the bankers much less room to cut interest rates in a crisis.

The reasons for the fall are broadly that saving has tended to increase and investment to fall; more money is available but fewer people want to borrow, thus driving down rates. The authors of the Bank of England paper argue the trends will not change abruptly so we can expect low rates for a long time.

They suggest savings have tended to increase in part for demographic reasons, because of rising inequality, and from a desire by Asian governments to maintain a financial buffer. The main demographic reason has not been ageing, but a decline in the dependency ratio: as birth rates have fallen, the proportion of people who were not of working age has fallen from 50% to 42% over the last 30 years. With fewer children people have been able to save more.

Piketty and others have pointed out the increase in within-country inequality over the last few decades, and since richer people save more than poor people, this too has tended to boost savings.