Are real interest rates high? - Organization for Economic Cooperation and Development countries

OECD Economic Outlook, June, 1993

Real interest rates in the 1980s were higher than they had been in the previous two decades. Although they are now lower in many countries than average levels in the period since 1980, there is concern that real interest rates are still too high for the current state of the cycle. The persistence of high real rates worldwide reflects several factors: large budget deficits, lags in market adjustment to the general disinflationary thrust of monetary policies since the early 1980s and financial liberalisation measures which have increased the extent to which key market interest rates reflect underlying market forces.

For more than a decade, interest rates appear to have been relatively high in real terms in most OECD countries, leading to fears that they may signal a shortage of global saving. This could result in lower investment, slower growth, and difficulties in providing adequate finance for developing countries and for reconstruction of central and eastern European countries and the New Independent States of the former Soviet Union.

This note examines recent and prospective interest-rate developments in the major seven OECD countries against the background of their behaviour in real terms during the past thirty years,(1) considering: i) whether real interest rates are high in a historical perspective; ii) explanations for the behaviour of real interest rates; and iii) reasons for international differences in this behaviour.

THE EVIDENCE

There are many conceptual and practical problems in measuring real interest rates. There is no such thing as the interest rate, even in nominal terms. Savers face different interest rates on available financial instruments, depending on the size of investment, marketability and risk, while the rates borrowers face depend on their credit-worthiness, the purpose of borrowing and the length of time for repayment. Tax considerations also influence both savers and borrowers in complex ways. Furthermore, adjusting nominal interest rates for inflation expectations involves selecting from a wide range of possibilities, none of which is ideal. Since inflation expectations are not directly observable, proxies have to be found. Possible proxy measures include recent past inflation and predictions based on simple time-series analysis, both of which suffer from being almost entirely backward looking. They also include forecasts by well-known institutions and survey data, both of which attempt to take account of forward-looking behaviour. Ex post inflation developments can also be used, a procedure which presumes a high degree of foresight on the part of economic agents.(2)

For the purposes of this note, measures of ex post inflation, proxied by changes in GDP deflators, were used to compute real interest rates. This involved adjusting nominal rates on representative low-risk long-term bonds (public sector bonds with maturity of about 10 years for most countries) and key nominal money market rates (3 months in most cases) in simple ways.(3) Real interest rates may be sensitive to the choice of inflation adjustment over short time periods, but average figures over long periods should be much less affected. Data are not strictly comparable on a cross-country basis and, in some cases, constructing a long time series has required linking different interest-rate series together.

The evolution since 1960 of real interest rates calculated on this basis are shown in Figure 9 for the seven major countries, in the form of averages for:

1960-67: a period of low inflation.

1968-79: a period characterised by high and accelerating inflation rates.

1980-92: a period of widespread disinflation and adjustment to a low-inflation environment in many countries.

Figure 10 shows real short and long rates on a semi-annual basis since 1990, including OECD Secretariat projections for 1993 and 1994, in order to examine real interest-rate behaviour during the current cycle.

Several features stand out from Figures 9 and 10:

* Since the beginning of the 1980s, real interest rates have been considerably higher than during the previous two periods. In most countries, real long-term rates have averaged between 4 and 7 per cent, and real short-term rates have only been slightly lower. In contrast, during the stable period before inflation took off in the late 1960s, real rates in most countries averaged around 1 to 3 per cent, with long rates typically a percentage point or so higher than short rates. During the intervening period of high and often rising inflation, real rates were low and in many cases negative, particularly at the short end.(4)

* Before the 1980s, and especially during the 1968-79 period, there was considerable dispersion of both short and long-term real rates across countries. Since 1980, there has been some convergence across countries, particularly for long rates.

* Since 1990, real long-term interest rates in the three largest countries have generally been lower than the relatively high average levels that prevailed in these countries over the period 1980-92. Elsewhere they have come down during the past year and are now below average levels of 1980-92 everywhere except in Italy. In many cases they are projected to decline further.