Why were interest rates so low even before the pandemic?

The financial crisis of 2007-08 it was caused in part by an excess of savings over investment in the global economy. The acute effect of this was an unravelling of the financial system in 2008 and although that acute stage has passed, the chronic issue remains. That is, the natural real rate of interest in the global economy – the rate of interest consistent with full employment – is extremely low, and possibly negative. The underlying reasons for this are globalisation (falling input and labour costs), demographics (ageing populations), and technological advancement (which increases productivity). In response, post-GFC and particularly since 2014, central banks have utilised ‘unconventional’ forms of monetary policy such as quantitative easing (QE) in an effort to lower the cost of borrowing and stimulate investment and broader economic activity.

The actual suppression of bond yields is driven not just by the mechanical que effect but also by market participants buying bonds in expectations of falling yields. Some of this is driven simply by forward guidance by central banks. From 2014 to 2019 central banks were calling – even if not explicitly – for more fiscal support to drive inflation and growth higher and raise the natural real rate of interest. Without fiscal support, central banks may have put their economies in a liquidity trap, whereby it requires more and more QE to get less and less activity response. The coronavirus pandemic has triggered a huge fiscal response leading some to suggest that the era of low inflation and interest rates is finally over. One of the key determinants of whether bond yields can stay low is how governments manage to pay back the debt they have issued in the QE and covid eras, whether they will pay it back at all, and even whether they need to bother trying. This latter point is related to modern monetary theory (something we suggest in another article), which suggests that as long as real resources are not scarce (particularly labour), then monetary expansion can continue indefinitely