Central Banks' Interest Rate Setting is Dead

Between rates too low to stimulate the economy during the next recession and rates too high to sustain government debt, interest rates are no longer the main tool for steering monetary policy. We are on the eve of a change in the way central banks operate and the emergence of a new tool.

Interest rates are too low to stimulate economies

During the 1990s, central banks gradually adopted inflation targeting (around 2%) and the interest rate as the main steering tool. This combination has worked well, since inflation has settled around the target and the inflationary episode of the 1980s seems more like a vague memory of another time than a new threat.

Interest rates are subject to the law of diminishing returns, and today their marginal efficacy is low, somewhere between homoeopathy and a placebo.

During the Great Financial Crisis of 2008, central banks rushed—and rightly so—to rapidly lower interest rates to close to zero and, at the same time, flood the financial markets with liquidity through Quantitative Easing (QE). As a global lender of last resort, the Fed introduced ‘heterodox’ tools with such as TALF, CPFF, and MMIFF.

These tools proved effective and were quickly included in monetary orthodoxy. In turn, the ECB launched LTRO, TLTRO I, TLTRO II, SMP, OMT, and CBPP during the euro crisis to stabilise the financial system and support the eurozone economies.

No one was then surprised that new liquidity programmes with catchy acronyms such as PEPP, TLTRO III, PELTRO, PDCF, PMCFF, SMCCF, MLF, etc. accompanied the cuts in rates caused by the COVID crisis.

Recent crises have shown that interest rates are no longer capable of stabilising the financial system and kicking off the next economic cycle. This is why QE measures are systematically implemented, with the result that public debt rises.

Interest rates are too high to sustain the government debt

If lowering interest rates to zero, or even negative territory, has become ineffective, what about rate rises? Well, rate rises are very—or too—effective, and so become unusable. The tool is asymmetric.

Rising interest rates are hurting credit demand, one of the engines of growth. In addition, the level of public debt is high. In Japan, the United States, the United Kingdom, Italy and France, the debt ratio exceeds 100% of GDP, and an increase in the cost of borrowing is putting governments with fragile public finances in difficulty. And the global financial system is based on ‘risk-free’ assets, essentially government bonds.

Moody's recently stripped US debt of its AAA rating, finally aligning its conclusions with the two other major rating agencies, Fitch and S&P, which believe this debt is no longer risk-free.

In an article published in February this year on US public debt (The United States on the Brink of Bankruptcy), I showed that interest rates cannot exceed a certain threshold above which US public debt is no longer sustainable.

The grey line in the graph below shows how this threshold has changed over the last 50 years in the United States. At almost 33% in the mid-1980s, this threshold has fallen steadily, reaching 4.6% in 2024, according to my estimates. This drastic fall in the maximum interest rate that the government can bear can be explained by a rise in debt, a fall in potential growth, and inflation. This rate is set to fall further over the next years.

For monetary policy, this means that the Fed cannot sustainably set interest rates above this threshold, as this would lead to a US debt crisis with catastrophic consequences. It is interesting to note that the Fed fund rate (orange line) crossed this threshold for the first time last year before falling back.

Graph 1: US interest rates hit a dead end

A central bank's room for manoeuvre is measured by its ability to stimulate or restrain an economy, i.e., its ability to deviate from the neutral rate, the interest rate that neither stimulates nor restrains the economy. The graph shows this rate in blue.

The combined reading of these three rates shows the gradual reduction in the Fed's room for manoeuvre. In the mid-1980s, the neutral rate was just over 17%, the Fed fund rate was 20%, and the maximum rate was 32.8%. The Fed had a wide range of action; it could still raise rates by more than 12 points if inflation accelerated further, cut rates by 20 points, and stimulate the economy with a rate 17 points below the neutral rate.

Today, these figures indicate that the Fed Fund rate (4.5%) is just right to sustain US public debt, as the maximum sustainable rate is 4.6%. With a neutral rate of 5,0%, the US central bank is forced to keep interest rates low, continuously stimulating the economy and leading to additional indebtedness.

As the saying goes, it is better to be roughly right than precisely wrong. Even if the estimates are open to debate, it is clear that the Fed's room for manoeuvre, and that of central banks more generally, is gradually diminishing, making interest rates an intervention tool too constrained to be used properly.

Conclusion

Central banks have several tools at their disposal to manage their monetary policy. Generally, they choose one primary tool and communicate extensively about it to make their decisions more straightforward to understand and transparent. For over thirty years, the interest rate has been the primary tool, but it is no longer the only one. Since the financial crisis, the various QEs with their improbable acronyms have made central banks' communications more cumbersome.

Today, lowering interest rates (already low) is no longer enough to stimulate the economy. As for an increase, it is limited by the level of public debt.

We are on the eve of a change in how central banks operate and the emergence of a new tool. My next article, which will be posted on Monday, June 23rd, on LinkedIn, will discuss this. Stay tuned.

This article is a translation of an original article published in French: https://www.allnews.ch/content/points-de-vue/la-fin-de-la-politique-des-taux-d%E2%80%99int%C3%A9r%C3%AAt