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Beyond Doughnuts. The ambiguous implications of low interest rates.

Economists have always assumed that lower interest rates boost consumption and reduce the propensity to save. The same logic is encouraging policy makers to pursue negative interest rates and raise inflation targets to push real rates even lower.

But the effects of lower interest rates on saving behaviour may change when rates are already very low.

In a speech on Tuesday, Glenn Stevens (Governor of Australia’s Reserve Bank) was the one of the first major policy makers to acknowledge a major concern of men and women in the Western world, and in doing so touched on what I think is one of the more problematic assumptions made by economists today.

“The key question is: how will an adequate flow of income be generated for the retired community in the future, in a world in which long-term nominal returns on low-risk assets are so low?”

How do you as an individual answer this question? When you can’t get as high a return on your investments, do you save more, or less?

Think about a rule-of-thumb people use in planning for retirement. If the yield on a 10-year Gilt is 5% and £50,000 is your target income, you need £1,000,000 of savings. Now do you save more or less if the yield on 10-year treasuries falls to 2.5%? You save more.

The problem is that the Federal Reserve and other central banks use models to set interest rates which assume that lowering interest rates causes people to spend more. They argue that most of us would rather have our money today than later and interest rates are the payment we receive for waiting. If rates are lower we are less happy to wait (or can even borrow), so we spend more money now.

What these two highly reasonable but conflicting models show is that as with many economic ideas, real world implications are not clear cut. One variable will not always have the same effect on another.

When Ben Bernanke was first criticised by the hedge fund manager David Einhorn about the self-defeating effects of ever-lower interest rates, my initial reaction was to side with Bernanke and view Einhorn as a crank. Einhorn argued that initially cutting interest rates is a good idea in the face of weak demand, but at some point it becomes counter-productive. He used the analogy of eating jelly doughnuts. To summarise: at a certain point you get sick.

Figure 1: Too much of a ‘good’ thing?

But the more I reflect on the effects of lower interest rates, I think the view of economists is complacent. The effects of rates cuts when interest rates are already very low may be fundamentally different to the effects when rates are high. In fact, this now seems so obvious.

Figure 2: Impact of rates on consumption not clear

There is a very good chance that when interest rates are already low and the yield curve is offering little to those planning for retirement, when long-term costs of health care and longevity are rising, and when credit conditions are far from easy for the young and those on low incomes, that lowering interest rates may actually result in less consumption. Reductions in interest rates or interest rate expectations around these levels don’t boost consumption – they boost desired savings.

You may be reading all of this and thinking: “Who cares? This is just another angle on secular stagnation, which everyone is talking about, and rates are rising, not falling”

However, part of the secular stagnation idea is that lower real rates lose their potency. But no policymakers or mainstream modellers are arguing that the relationship between real interest rates and desired savings could actually be negative. If this is true it would have critical policy implications: if you are worried about insufficient demand, negative nominal interest rates and higher inflation targets to bring real interest rates lower may backfire. Lower real interest rates may actually make the problem worse.

This has a very significant bearing on contingency planning for policymakers. We may be in the middle of a sustained global recovery which allows real interest rates to gradually rise (see figure 3). But we may not. In which case, if lower real interest rates potentially make matters worse, we need alternative policies. This consideration is particularly acute for Europe.

Figure 3: Rates may rise gradually… or not

A change in attitudes towards fiscal policy is one option as Krugman, Summers, DeLong and Wren-Lewis have argued. New tools for central banks is the other.


The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.