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SPEECH

Determinants of the real interest rate

Remarks by Philip R. Lane, Member of the Executive Board of the ECB, at the National Treasury Management Agency

Dublin, 28 November 2019

Introduction

• It is a pleasure to address the Annual Investee and Business Leaders Dinner organised by the National Treasury Management Agency (NTMA).
• [1] I plan today to explore some of the factors determining the evolution of the real (that is, inflation-adjusted) interest rate over time.
• More generally, the real interest rate is at the core of many financial valuation models, while simultaneously acting as a fundamental macroeconomic adjustment mechanism by reconciling desired savings and desired investment patterns.
• The real return on government bonds in advanced economies has undergone pronounced shifts over time.
• Chart 1 shows that, since the 1980s, the real return on sovereign debt has registered a steady decline towards levels that are low from a historical perspective.
• Looking at the 1970s, ex-post calculations of the real interest rate were also low during this period, since inflation turned out to be unexpectedly high.
• In contrast, the current low levels of the real interest rate take the form of low nominal yields, since inflation is itself low and stable.

The natural rate of interest

• The falling trend in yields can be interpreted as a decline in the so-called natural or neutral rate of interest (labelled as r* in academic research and policy discussions).
• The natural rate of interest corresponds to the level of the real short-term interest rate that defines a neutral policy stance: this corresponds to a situation in which the economy is operating at potential and inflation is at its target value, such that there is no reason for the central bank to either inject or withdraw stimulus.

Causes of the persistent low real yield environment

• I will structure my discussion of the drivers of r* around three broad driving forces: first, the determinants of potential growth rates; second, demographics; and third, diverging developments in the returns on risky and safe financial assets.
• [3] These three factors are embedded in the textbook economic growth model, which relates the equilibrium rate of interest to economic growth, population growth and the discount rate.
• I will primarily focus on common international trends, even if cross-country differences in these driving forces have important implications for return differentials and international capital flows.

The potential growth rate

• One fundamental driver of r* is the potential growth rate of the economy: in a high-growth economy, it takes a higher real interest rate to encourage the volume of saving required for the high investment levels needed to sustain a fast-growing economy.
• Although easier to see with the benefit of hindsight, there has been a sustained decline in the potential growth rate of advanced economies in recent decades: it is estimated to be less than half of what it was 50 years ago (Chart 2).
• The decline in potential output growth in turn can be attributed to a decline in total factor productivity growth (Chart 3) and a corresponding decline in labour productivity growth (Chart 4).
• [7] Chart 2 Potential output growth and long-term growth expectations (percentages per annum) Sources: Bureau of Economic Analysis, European Commission and Consensus Economics.


Chart 3 (yearly growth rates, percentages, five-year moving averages, constant prices) Sources: European Commission AMECO database and ECB staff calculations. Notes: The euro area reflects data for the original 12 member states.
Labour productivity: real gross value added per person employed (yearly growth rates, percentages, five-year moving averages, constant prices) Sources: European Commission AMECO database and ECB staff calculations. Notes: The euro area reflects data for the original twelve Member States.

• A range of inter-related structural and technological factors have been advanced to explain the decline in the potential output growth rate.
• Assessing the determinants of the rate of technological innovation is beyond the scope of this speech.
• [8] In addition to the pace of frontier innovation, aggregate productivity growth also depends on the rate of technology diffusion.
• There are signs that the diffusion rate has slowed: for instance, the gap between the labour productivity growth of firms operating at the technology frontier in a given sector and that of firms that are lagging behind the technology frontier in that sector (non-frontier firms) has increased over time (Chart 5).
• The productivity growth of the euro area is proxied as the unweighted average across Belgium, Spain, France, Italy and Finland of the median firm in each 1-digit sector (using the NACE Rev.
• One candidate is the fall in business dynamism as measured by business churn: the rate at which firms exiting the market are replaced by new ones has declined measurably over the last decade (Chart 6).
• Chart 6 Business churn in the euro area and United States (sum of the birth and death rates of firms) Sources: Eurostat and United States Business Dynamics Statistics.
• Note: The euro area is represented by Belgium, Germany, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal, Slovenia and Finland.
• Employment growth has been concentrated in the services sector in recent years, and productivity growth in services has been weaker than in other sectors, such as manufacturing and information technology.
• As a result, the growing share of services in total employment mechanically implies a drag on productivity growth in the economy as a whole (Chart 7).
• Assuming that the structural shifts I have just described account for a loss in potential output growth of around 1percent, a back of the envelope calculation suggests that these account for a decline in real equilibrium yields of a similar magnitude.
• In particular, there is a wide range of views about the potential economic impact of digitalisation, automation and artificial intelligence, which depends on the success rate in converting new technologies into economically-successful business applications.
• On the other side, the carbon transition is also a spur for investment and opens up new opportunities for innovation and productivity growth.

Demographics

• Let me now turn to a second driving force for the real interest rate: demography.
• Over the last 50 years, demographics in advanced economies have been characterised by low fertility rates and rising life expectancy (Chart 8).
• As a result, people now expect to enjoy many more years in retirement than they did in the 1970s, as Chart 9 shows for the euro area.
• Chart 8 Life expectancy at birth: historical data and projections (number of years) Notes: Annual data.


Chart 9 Expected number of years spent in retirement for the largest euro area countries (number of years) Sources: World Bank, United Nations, Eurostat, OECD and ECB staff calculations. Notes: The chart reflects the difference between life expectancy at birth in year t and the effective retirement age in year t. The chart is a population-weighted average for Germany, France, Italy and Spain.
Old-age dependency ratios: historical data and projections (ratios) Sources: World Bank, Eurostat, OECD and ECB staff calculations. Notes: Dashed lines denote projected values. For the euro area, historical data are from the World Bank and projections are from Eurostat. All other historical data and projections are from the OECD.
Chart 11 Older worker ratio: ratio of 40-64 year olds over 15-64 year olds (ratios) Sources: World Bank, Eurostat, OECD and ECB staff calculations. Notes: Dashed lines denote data points based on projected values. For the euro area, historical data are from the World Bank and projections are from Eurostat. All other historical data and projections are from the OECD.
Chart 12 Working-age population growth: historical data and projections (year-on-year growth rates) Sources: World Bank and ECB staff calculations. Notes: Annual data. Dashed lines denote projected values. Projections begin in 2018.

• This in turn is due to the fact that the ratio of installed capital relative to the size of the work force increases as the population ages.
• Second, ageing can lower productivity growth and thereby reduce investment opportunities.
• This materialises if the productivity of older age cohorts is lower than that of younger age cohorts.
• [13] While demographics constitute a powerful inter-generational influence on aggregate savings, the intra-generational distribution of income also matters.
• The base unit is the tax unit defined by national fiscal administrations to measure personal income taxes.
• The first observation is 1970 for Japan and the United States, and 1980 for the European Union.

Diverging trends in the return on capital and on safe financial assets

• A further complication relates to shifts in the relation between the return on so-called safe assets (such as highly-rated sovereign bonds) and wider measures of rates of return, including equity returns and returns on higher-risk debt instruments.
• On the other, the demand for short-term money-like instruments has surged, and the yield on those instruments has dropped to unprecedented negative values.
• 1692-1720; for equity risk premium Thomson Reuters, Consensus and ECB staff calculations.
• Notes: Corporate bond spreads for the United States before 2010 are based on Gilchrist, S. and E. Zakrajek (2012), ibid.
• Owing to historical data constraints, the equity risk premium is approximated by subtracting the real risk-free rate from the earnings yield.
• [17] This literature also highlights the increasing value attached to safe assets that offer protection against downside risks.
• [18] The premium on safe assets is due to several inter-related factors, with the relative importance of individual factors shifting over time.
• First, ageing may play a role in moving portfolio preferences towards lower-risk assets, with older savers seeking safer income streams as retirement approaches.
• Third, the safety premium also reflects the lingering effects of the global financial crisis and the euro area sovereign debt crisis (Chart 15).
• By revealing the harsh costs of exposure to financial disasters, such crises tend to shift portfolio preferences in the direction of assets that preserve their value during bad times.
• In the euro area the ratio of highly-rated short-term assets relative to GDP appears low in international comparison (Chart 17).
• More generally, safe asset scarcity tends to be most visible in yields on assets that provide the best hedge against liquidity, interest rate, or default risk (Chart 18).
• [21],[22] Chart 16 Share of euro area sovereign bonds with AAA rating (left-hand scale: percentages; right-hand scale: number of sovereign issuers) Source: ECB.


Chart 17 Share of short-term government debt with AAA rating relative to GDP (percentages) Source: ECB and US Treasury. Notes: Ratings based on Moody’s, Fitch, Standard & Poor’s and DBRS. AAA-rating based on at least one of its ratings being AAA. Short-term debt refers to securities with a residual maturity of up to and including 2 years.
Chart 18 Two-year German government bond yield to OIS spread (basis points) Sources: Thomson Reuters and ECB staff calculations. Note: Daily data.

Empirical Summary

• The decline in potential growth rates, demographic trends and the portfolio shift towards safe assets combine to put downward pressure on the equilibrium real rate of interest.
• However, analysis by the ESCB Working Group on Econometric Modelling indicates that, taking the impact of these driving factors into account, the equilibrium real interest rate in the euro area has been around zero or negative in recent years (Chart 19).
• [23] Similar estimates are reported in the growing literature on the global equilibrium real interest rate.
• [24] While Chart 19 shows that estimates of r* are inevitably not very precise, the general downward drift is quite clear.
• Corresponding individual point estimates are reported in Brand, C. et al.
• Sources: Fiorentini, G., Galesi, A., Prez-Quirs, G. and Sentana, E. (2018), The Rise and Fall of the Natural Interest Rate, Documentos de Trabajo, No 1822, Banco de Espan; Hledik, T. and Vlcek, J.
• 59-75; Jarocinski, M. (2017), VAR-based estimation of the euro area natural rate of interest, ECB Draft Paper.

Policy Issues

• Prepared by Desislava Andreeva, Maciej Grodzicki, Csaba Mr and Alessio Reghezza[1] Low aggregate bank profitability in the euro area, which weakens the resilience of the euro area banking sector, is partly explained by the persistent underperformance of a sub-set of banks.
• These banks all stand out in terms of elevated cost-to-income ratios.
• The common cost inefficiency problem seems most pronounced for the largest and smallest banks.
• But in systems with many weak-performing small banks, consolidation within their domestic system could improve performance.

1 Introduction

• Retained bank profits form the first line of defence to absorb losses and build up capital positions.
• In recent years the euro area banking system has seen return on equity below the estimated cost of equity.
• Previous ECB analysis has examined the potential drivers of low profitability including cyclical and structural factors.
• Yet, over time, structural issues such as poor cost-efficiency, overcapacity, competitive dynamics and insufficient income diversification have come to the forefront.
• [3] Structural changes in the banking sector need to be part of the solution to the weak bank profitability problem.
• This special feature furthers this discussion by examining the issues faced by the weakest-performing banks in the euro area and by drawing out implications for possible solutions.

2 Who are the underperformers?

• Persistent underperformance by a sub-set of banks explains much of the weakness in overall euro area bank profitability.
• While the median significant institution (SI) earned a return on equity close to 6% between 2015 and 2018, about one quarter of institutions achieved less than 3%.
• The cohort of underperforming significant institutions is identified as those which recorded a below-median return on equity in at least three years between 2015 and 2018.
• Moreover, the group is heterogeneous across multiple standard metrics of balance sheet strength and efficiency (e.g.
• Cluster analysis finds some common patterns and identifies key drivers of weak profitability in the group of underperformers.
• Chart A.1 A number of banks have showed persistently weak profitability over recent years, with the group of underperformers dispersed geographically
• The banks in this group do exhibit a relatively high income-to-assets ratio, reflecting higher interest rates to less creditworthy borrowers.
• However, the higher cost of managing troubled assets results in an elevated cost-to-income ratio.
• Unsurprisingly, most banks in group 1 are located in countries more affected by the euro area debt crisis such as Greece, Italy, Cyprus and Portugal.
• Group 2: Weak revenues: Low profitability appears to be driven by weak income-generation capacity.
• This cluster is dominated by German lenders, potentially highlighting the high degree of price competition in this market.

3 The common cost and overcapacity problem

• An elevated cost-to-income ratio is a common feature for all groups of poorly performing banks.Therefore, this special feature goes on to estimate cost inefficiencies for various classes of banks.
• In a first step, each banks costs are benchmarked against the best performers in the industry.
• The analysis covers a comprehensive sample of commercial, cooperative and savings banks in the euro area.
• Subsequently, a banks actual efficiency is measured relative to the estimated optimal cost structure.
• Banks with total assets of more than 30 billion as well as particularly small lenders exhibit pronounced cost inefficiencies.
• Chart A.3 Cost inefficiency is most pronounced among the smallest and the very large banks
• Small commercial and savings banks and large cooperative banks seem to operate with particularly sub-optimal cost structures.Chart A.4 presents the cost (in)efficiency metric by bank type.
• This finding, however, may be distorted by the complex range of financial services offered by these banks.
• As some of them are only imperfectly captured in the analysis,[7] cost inefficiencies may be overstated.
• Second, cost inefficiencies among the smallest banks appear significantly elevated for the group of commercial and savings banks compared with larger peers.
• Chart A.4 Cooperative, commercial and savings banks differ in terms of cost efficiency (2018; x-axis: banks by type and size; y-axis: bank efficiency, relative to frontier; percentages)
• Recent empirical evidence suggests that euro area banks across all size categories also operate on an inefficient scale.
• Moreover, some researchers point to information technology as a possible source of economies of scale in banking.
• [10] But improving operational efficiency could be impeded by structural features of the euro area banking market.
• [11] However, the stickiness of the cost base of euro area banks may reflect a deeper market structure issue.
• [12] Some of these competitors operate under a non-profit charter, which reduces the market-based incentives to tackle overcapacity.
• Overcapacity is also visible in evidence of limited pricing power for many banks.
• Bank loan-deposit margins in many euro area countries have been falling in the recent years.
• By contrast, large banks with total assets in excess of 30 billion command significant pricing power compared with the rest of the system.
• Chart A.6 Overcapacity in the euro area banking sector may lead to unhealthy competition, which has an impact on pricing behaviour

4 Remedies should be tailored to the causes of low profitability

• From a financial stability perspective, the objective in addressing weak bank profitability is to create a healthy and resilient banking sector.
• A successful response would address the specific driver of low profitability for each group of weak performers and reduce overcapacity in the euro area banking system overall.
• At the same time, actions must avoid pitfalls such as allowing excessive market power or boosting the systemic footprint of large institutions.
• First, weak profitability because of a high stock of non-performing loans could be addressed by policies targeting the legacy asset problems.
• Where the problems are idiosyncratic in nature, an acquisition of the sound parts of the business by a healthy bank may be possible.
• Where much of a countrys banking system suffers from a legacy asset problem, acquisition and consolidation become less relevant.
• Second, in systems with many weak-performing and very small banks, consolidation within their domestic system could improve performance.
• Chart A.7 M&A activity in the euro area banking sector has been very subdued since the global financial crisis
• [20] A healthy level of competition should enhance efficiency and promote product innovation, lowering interest rates and, in turn, reducing firms borrowing costs and probability of default.
• An aggressively competitive market can lead banks to take on too much risk, while also squeezing their margins and undermining their resilience.
• Combining measures of competitiveness and stability of the euro area banking sector can shed light on whether the current level of competition is enhancing or potentially undermining financial stability.
• [21] Since 2001 the increase in the market power of the median euro area bank has been overall positive for financial stability.
• Higher values of the index are associated with stronger market power and reflect weaker competition.
• Chart A While the market power of euro area banks has been increasing, it did not pass the point where further increases would be detrimental to financial stability

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