Perspective

The Zero: why interest rates will stay low


Low interest rates are not new. However, what makes the current environment unique is the low level of government bond yields. Policymakers have stepped up their asset purchase programmes to help drive down long-term bond yields to record low levels. It is not just short rates which are at “The Zero” in many markets, so are bond yields.

Although we expect economic activity to rebound significantly in the second half of 2021, interest rates are unlikely to follow.

Inflation holds the key

As the economy begins to re-open, there will be upward pressure on prices and we are already seeing some bottlenecks emerge in the more buoyant goods sector.

However, this is likely to be a transitory effect as economies will go into the recovery with significant spare capacity, particularly in the labour market. For a transitory increase in prices to turn into a persistent acceleration in inflation, we would need to see wages picking up and adding a further round of cost pressure to prices. This seems unlikely with unemployment well above estimates of equilibrium around the world.

While the relationship between unemployment and wages has weakened somewhat in recent years, the signal is still one of deflationary pressure on wages for a considerable period as workers compete for jobs.

In our forecasts, the US output gap does not close until the middle of 2022 and later in the UK and eurozone. Consequently, after a brief pick-up once economies re-open later this year, inflationary pressure is likely to ebb until later in 2022.

This is not an outlook which will trouble policymakers as it comes against a backdrop where inflation is already low and central banks recognise that past policies have been too tight and deflationary to hit their inflation targets. The latter has been most clearly highlighted by the decision by the Federal Reserve to shift its inflation target to one where inflation averages 2% over the cycle.

As the economy emerges from recession, we would expect the Fed to keep rates low and policy loose for a period to achieve its new target. Such a move would also give the Fed a greater chance of reaching its maximum employment goal where a broader group of families and communities share in the benefits of economic growth.  

Of course, we would not rule out a period of higher inflation, but on balance, we believe that the disinflationary trend which was established in the world economy before Covid-19 will reassert itself. One reason why is simply the level of debt in the world economy. Figures from the IMF show that government debt in the advanced economies has reached levels last seen after the Second World War.

High government debt levels will reinforce low rates

While some see high debt as a precursor to higher inflation, suspecting that the authorities will try to and succeed in devaluing their liabilities through inflation, this is not what we’ve seen in Japan.

We do see significant differences between Japan and other economies which means that they need not follow along the same deflationary path. However, looking further ahead, with debt heading above 100% of GDP in the US and UK and both countries facing significant healthcare liabilities, fiscal space will become more limited.  

In this environment, the pressure on central banks to keep rates low will remain strong. Not just to maintain overall policy stimulus, but to ensure that high debt levels remain sustainable. The need to boost inflation and facilitate high budget deficits and debt mean central banks will keep policy loose as the world economy recovers.

We are in unprecedented times, but the likelihood is that low interest rates will persist long after the world economy has shaken off the pandemic. For financial markets, such an outlook will intensify the search for yield and no doubt create volatility and bubbles as investors chase returns in “the zero” environment.

Important Information
The contents of this document may not be reproduced or distributed in any manner without prior permission.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect nor is it to be construed as any solicitation and offering to buy or sell any investment products. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Any security(ies) mentioned above is for illustrative purpose only, not a recommendation to invest or divest. Opinions stated are valid as of the date of this document and are subject to change without notice. Information herein and information from third party are believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. You may not get back the full amount invested. Derivatives carry a high degree of risk. Exchange rate changes may cause the value of the overseas investments to rise or fall. If investment returns are not denominated in HKD/USD, US/HK dollar-based investors are exposed to exchange rate fluctuations. Please refer to the relevant offering document including the risk factors for further details.
This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.