Why are interest rates so low?

We all know what this feels like. Since the global financial crisis, the recovery in demand has been disappointing, growth has been slow and the low level of demand has generated lower inflation.

What is important is how Central Banks react. Central Banks have responded to the low level of demand and lower inflation by cutting interest rates. In many countries they have cut interest rates all the way down to zero. Official interest rates have been zero even though inflation has been positive. This of course means that at least at the short end of the yield curve we have been re-entering the world of negative real interest rates. When this is maintained for many years, this reduces the level of sovereign debt at the short end of the yield curve. But wait, there's more.

The great innovation of Central Banks since the global financial crisis has been 'quantitative easing'. This means that Central Banks have been buying long term debt and reducing the yield on long term debt relative to inflation. This has reached the point in the Euro Area where as we speak, German 10 year bunds have fallen to a yield of 70 basis points. They were even lower than this earlier in the year.

Now for long term yields to be low enough to reduce net debt to GDP, they only have to be lower than nominal GDP for that year. We can rest assured that the combination of GDP growth in Germany plus even slight inflation will be higher than 70 basis points in 2015. This means that this market driven form of financial repression will be working to reduce German debt this year.

The same will be true of other European countries with even slightly higher interest rates on their long term debt. As long as countries can get a reasonable control of their budget deficits, this combination of low interest rates on long term debt plus modest inflation, will serve to reduce debt to GDP in the long term.

Conclusion

The data tells us is that we are living through the second great age of financial repression. The high level of public debt in developed economies and the reduction in income from servicing the interest rates on that public debt is reducing demand. Central Banks are responding to that fall in demand by giving us very low levels of interest rates.

We are facing an extended period of low real interest rates in the developed world. These low real interest rates will help to repay public debt. However, this process will take many years. The result will be an extended multi year period of low interest rates.