The move was part of a global trend which reflected large macroeconomic forces, including: an increasing share of the global population being of prime working age; the rise of global inequality; the adoption of inflation targeting over the course of the 1990s; and the global imbalances that emerged in the early 2000s in which a glut of savings from emerging economies flowed to advanced economies. 1 Pension reforms in the UK – also over the course of the 2000s – created a further incentive to invest in long-dated bonds to better match defined-benefit liabilities. Of course since then we have had the global financial crisis and its aftermath, during which long yields declined further, reaching new lows in the first months of this year. More recently we have seen some quite sharp moves higher. But on any historical comparison long term interest rates are still at exceptionally low levels. How should we interpret them? A starting point is the pure expectations hypothesis, which says that the long term yield should reflect the market’s expectation of the average short term yield over that period. If that is true, then it suggests that Bank Rate is expected to average 2½% over the next 20 years (about half of its pre-crisis average of 5%). From that it would be easy to infer that financial markets are expecting either very low investment and growth, or very low inflation, or both.
If the Fed were to raise its rates, it would be a sign that growth and employment indicators are robust in the United States. This, essentially, would be good news for Europe. Despite all of the ECB’s efforts to inject liquidity, large companies in the euro area are sitting on mountains of cash and not investing… Monetary policy is supporting the recovery in demand and has removed a key obstacle to investment – financing. But obstacles remain on the supply side. Weak investment, even though financing costs are low, shows that there is a dearth of projects that are sufficiently profitable in the long term. This reveals a lack of productivity and innovation. The ECB cannot do much about that. On top of this, there are external risks: slowing global growth, particularly in large emerging economies. In other words, it’s pointless to expect that an eventual increase in quantitative easing will be enough to stimulate investment… Quantitative easing, by pushing back the horizon for monetary policy action, removed the financing obstacle. Lending rates to enterprises have fallen significantly, including in the stressed euro area countries. What we can do, what we must do, is maintain confidence in inflation returning towards our objective of 2%. The ECB, within its mandate, cannot accept inflation stabilising in the vicinity of 1%. You regularly underline the risks of inflation and growth being too low. But there are always risks – the sky could fall in!