High interest rates can cause inflation

About the causes and the possible end of the low interest rates in Germany

Interest rates in Germany and the euro zone are too low - this statement is being made more and more frequently in the German press. The European Central Bank (ECB) is implicitly - and some also explicitly - assumed that it is setting the nominal interest rate artificially low so that the governments in the southern member states of the euro zone can finance themselves with cheap loans. A thorough analysis shows, however, that the low interest rates are not the result of central bank policies, but also, above all, of structural factors - a low supply of safe securities, the low real economic growth rate and productivity up to demographic development and an increase in income inequality - lies. An end to the phase of low interest rates cannot therefore be achieved by increasing key interest rates, but only through a clever economic and financial policy, especially in Germany.

When talking about “the interest”, it must first be clear: There is no uniform interest rate. Depending on how high the risk of loss of an investment is, the respective interest rate varies, as it contains a risk premium. Currently, interest rates on risky assets are not particularly low, as many equity and real estate owners can attest. The “low interest rate” that the ECB can influence, on the other hand, means the risk-free interest rate. B. pays a federal bond or the savings account.

Supply and demand determine the interest rate

This interest rate, or more precisely the nominal interest rate for ten-year German government bonds, is shown in Figure 1. In an economy, the nominal interest rate is primarily determined by the central bank. The ECB is currently influencing this interest rate through the Public Sector Purchase Program. Within the predecessor of this program, which ran from March 2015 to December 2018, the ECB already bought securities worth EUR 2.5 billion. The new acquisition program began in November 2019.

illustration 1
Development of inflation, nominal and real interest rates in Germany

This program increases the demand for risk-free securities and thus leads to an increase in their price. Since investors now have to pay a higher price for the promised disbursements of the securities, the profit from these securities and thus their interest rates decrease. The demand for short-term Bunds is so great that the interest rate is negative. This means that investors make a loss with the purchase of the bond. The demand for risk-free securities has continued to increase in recent years due to the requirement for commercial banks to invest in safe securities in order to better weather a future financial crisis, thus further reducing the nominal risk-free interest rate.

Increased demand contrasts with decreased supply

The increase in the demand for risk-free securities has been offset by the shortage of supply in recent years. Figure 2 shows the share of risk-free bonds relative to gross domestic product for the euro zone and the US. While investors in the euro zone have less than 10% safe bonds available, in the US it is over 30%.

Figure 2
Share of risk-free securities relative to gross domestic product
AAA-rated short-term debt

Source: own calculations.

The supply of risk-free securities in the eurozone has decreased for two main reasons. First, the financial and sovereign debt crisis has resulted in fewer countries in the eurozone that are given risk-free status by rating agencies. In 2007 there were eight countries that were certified by at least two rating agencies to be able to issue risk-free debt securities, in 2019 there are only three countries. Second, Germany, the largest and most important economy in the euro zone, has drastically reduced its debt ratio from just over 80% to around 60% in recent years.

Nominal and real interest rates

However, the nominal risk-free interest rate is not the interest rate that is relevant for households and companies in an economy. This is the real interest rate, i.e. the interest rate that remains after deducting inflation from the nominal interest rate. In Figure 1, in addition to the nominal interest rate, we also show the development of the real interest rate for Germany. This interest rate is important for the consumption decisions of households and the investment decisions of companies. The higher the interest rate, the more expensive loans are to finance investments or durable consumer goods. Therefore, in a recession, the central bank tries to lower the real interest rate by lowering the nominal interest rate.

Lessons learned from history

The sharp interest rate cuts after the financial crisis in 2007/2008 were motivated by the devastating effects of the global economic crisis with a drop in economic output of more than 5% in less than a year. How should central banks react to this crisis? Many have learned from financial crises from a historical perspective, especially from the world economic crisis in the years 1929 to 1933. As in the 2007/2008 crisis, gross domestic product plummeted in 1929. The low demand for goods, which was made up of a slump in investment and consumption, led to a significant drop in prices. At that time, however, the central banks did not react with a strong anti-cyclical policy.1 The government under Chancellor Brüning even accepted falling prices and deflation.

Figure 3 shows the negative trend in prices.

Figure 3
Development of the real interest rate and price changes in Germany

Source: V. Daniel, L. ter Steege: Inflation expectations and the recovery from the Great Depression in Germany. Explorations in Economic History, 101305, 2019, https://doi.org/10.1016/J.EEH.2019.101305 (14.1.2020).

The figure shows the sharp rise in real interest rates caused by deflation.2 The high interest rates led to a further slump in investment and thus exacerbated the economic crisis in Germany. The turning point in interest rates in August 1932 came too late to prevent the National Socialists from coming to power. Figure 1 shows that these deflationary tendencies also existed in the eurozone after the financial crisis. However, with its monetary policy, the ECB was able to prevent deflation and thus another severe recession in the euro zone3 - the ECB has thus drawn the right lessons from history and avoided the mistake of an overly restrictive monetary policy, as in 1929 to 1933, even if some German critics doubt this.

The concept of the natural real interest rate

While monetary policy and the increased demand for risk-free investments that go hand in hand with a shortage of supply are important reasons for the relatively low real interest rate, other factors also play an important role. In order to be able to work out the further causes for the low interest rate, the concept of the natural real interest rate is considered. This is understood to be the real interest rate that would arise in an economy with flexible prices in which there is full employment. The central bank cannot influence this interest rate. Since the natural real interest rate is a theoretical concept, it cannot be observed, but only estimated using an empirical model. Figure 4 presents the estimates by Fries et al.4 The natural real interest rate has been low in Germany for some time and, with the exception of the period around 2010, even negative. Since monetary policy is out of the question as the cause of the low natural real interest rate, there must be other reasons for the negative natural real interest rate.

Figure 4
Estimate of the natural real interest rate for Germany

Source: S. Fries, J.-S. Mésonnier, S. Mouabbi, J.-P. Renne: National natural rates of interest and the single monetary policy in the euro area, in: Journal of Applied Econometrics, 33rd Jg. (2018), H. 6, pp. 763-779.

Reasons for a low natural real interest rate

There are currently four main reasons for the low natural real interest rate:

Low potential real economic growth

A first reason for the low natural real interest rate is the low potential real economic growth. The low potential growth is due, among other things, to low productivity growth. The reasons for the low growth in productivity in the euro zone are, on the one hand, the low diffusion of technology from companies that work at the limit of technological progress to other companies operating in the same sector that are less technologically advanced. On the other hand, there was an expansion of the service sector in the euro zone at the expense of the manufacturing sector. However, productivity increases in manufacturing are much higher than in the service sector

Demographic development in the euro zone

In addition to the low productivity growth in recent years, another trend also plays an important role in the low natural interest rate: the demographic development in the euro zone. Life expectancy in the euro zone has risen continuously since 1970 from a little over 70 years to currently over 80 years. Since the retirement age has not and will not be increased accordingly at the same time, the time that people spend in the third phase of life, the retirement age, also increases. The increase in retirement time and the number of pensioners will not be offset by strong population growth. Correspondingly, the ratio of the old population to the young population (the “old-age-dependency ratio”) in the euro zone is growing from around 20% in 1970 to around 30% today. In 2050 the ratio will be over 50%. This means that fewer and fewer young people have to pay for the pension of the older population.

The demographic trend is leading to an increased motivation for precaution among the aging population and thus to increased savings behavior. The additional capital made available in this way has fewer uses. Productivity growth is low and demographic developments mean that there are fewer workers who need to be provided with new capital. The increased supply of capital meets a lower demand, the compensation for foregoing consumption, or the reward for saving, the real interest rate, falls. The precautionary motive now means that although the real interest rate is low, the capital is not consumed. It just has to be saved.

High savings rate in Germany

Thirdly, the high savings rate in Germany is increasingly a problem and one of the reasons for the low nominal and real interest rates in the entire euro zone. The German economy accounts for almost a third of the entire economic output of the euro zone, at the same time the German economy achieves net savings of almost 7% of its own economic output or 230 billion euros per year. The high net savings are reflected in Germany's massive current account surpluses for many years - a violation of European rules.

Increase in income inequality in the euro zone and in Germany

A fourth reason for the low natural real interest rate is the rise in income inequality in the euro zone and in Germany. In 1980 the income of the top 1% was around 7%, it is now over 10%. While low-income households consume most of their income and will mostly consume an increase in income, the top 1% only consume a fraction of their income. An increase in income therefore tends to lead to an increase in savings behavior. This saving takes place in a similarly non-elastic way, i. H. almost regardless of the level of the interest rate: since the money cannot be consumed, it must be saved. The increase in the supply of capital is not offset by the increase in the demand for capital, which means that the real interest rate falls.

Possible solutions for higher real interest rates

In and of itself, low real interest rates are neither good nor bad. They are good for debtors and for businesses, citizens, and states that want to invest. In contrast, they represent a challenge for citizens who are used to investing their savings in safe bonds, such as government bonds or savings accounts. At the same time, it must not be ignored that citizens are not only savers, but also employees and taxpayers. While low interest rates may make saving in the savings account difficult, it helps some find work and earn better incomes 6 as well as pay lower taxes 7

Caution is therefore advised with calls for an interest rate hike by the ECB. An increase in the key interest rate of the ECB would also have the consequence that investment and thus demand in the euro zone would decline, as a result of which the central bank would now have to lower nominal interest rates again in order to give the economy a new impetus and to prevent a more severe recession .8 The following nominal and real interest rates could even be below the current level. Under certain circumstances, there is even a risk of a repetition of the situation at the end of the Weimar Republic: falling prices, which raise real interest rates and cause a deep recession due to a lack of investment. The call for the central bank to increase nominal interest rates is therefore misleading and false.

Another way to increase nominal interest rates is to increase the availability of public debt with a high credit rating. That would include federal bonds. The federal government could end its “black zero” policy, make more productive investments and take on new debt, thereby increasing the supply of high quality debt securities. The increased supply would lower the price and increase the interest rate. Since the interest that the German state would have to pay on the debt would still be lower than the economic growth rate, borrowing would hardly be a burden for future generations.

The borrowed debt would directly increase nominal interest rates and thereby real interest rates in the short term. They could also be used to support the natural real interest rate drivers. Government investment in better training increases the labor productivity of employees. Investing in modern, sustainable infrastructure also improves the productivity of an economy. 9

Another possibility of increasing the natural real interest rate is to use political measures to cushion the precautionary motive of demographic change in the population. This includes raising the retirement age or increasing the young population through targeted immigration. Since a further cause of the low natural interest rate is the increase in inequality, the state can contribute to an increase in the natural real interest rate by introducing another tax class with a higher top tax rate. The tax revenues could then in turn be used both for higher investments and for a subsidy for pensions.

The conclusion of the article is therefore that it is not monetary policy that can be made responsible for increasing interest rates, but that it is above all the German state that is raising the real interest rate in the short term through a clever investment program and increased provision of debt instruments can. Through further investment activity, a reduction in income inequality and reforms that lead to a reduction in the personal pension motive due to demographic change, German politics can also put an end to the low natural real interest rate.

  • 1 M. Friedman, A. J. Schwartz: A Monetary History of the United States, 1867-1960, Princeton 1963.
  • 2 While positive price growth (inflation) lowers the real interest rate while nominal interest rates remain stable, negative price growth (deflation) increases the real interest rate.
  • 3 M. Rieth, L. Gehre: ECB bond purchase programs raise inflation expectations in the euro area, DIW weekly report, 2016.
  • 4 S. Fries, J.-S. Mésonnier, S. Mouabbi, J.-P. Renne: National natural rates of interest and the single monetary policy in the euro area, in: Journal of Applied Econometrics, 33rd Jg. (2018), H. 6, pp. 763-779.
  • 5 European Central Bank: The slowdown in euro area productivity in a global context, ECB Economic Bulletin, No. 3, 2017; D. Pilat, C. Criscuolo: The future of productivity. in: Policy Quarterly, 14th year (2018), no.3.
  • 6 M. Hachula, M. Piffer, M. Rieth: Unconventional Monetary Policy, Fiscal Side Effects and Euro Area (Im) balances, SSRN Electronic Journal, https://doi.org/10.2139/ssrn.2815463 (10.1.2020) .
  • 7 M. Fratzscher: The German saver is one of the winners, Zeit Online, August 19, 2019, https://www.zeit.de/wirtschaft/2019-08/niedrigzinsen-sparer-ezb-geldpolitik (January 14, 2020).
  • 8 M. Fratzscher, M. Lo Duca, R.Straub: ECB Unconventional Monetary Policy: Market Impact and International Spillovers, in: IMF Economic Review, 64th year (2016), no. 1, pp. 36-74.
  • 9 F. Fichtner, M. Fratzscher, M. Gornig: An Investment Agenda for Europe, DIW Weekly Report, No. 24, 2014.