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Why are interest rates so low? And how long will they stay that way?

Now that the European Central Bank has passed another historic milestone by imposing negative interest rates on a major part of the world economy, there is one explanation of the unprecedented collapse of interest that everyone can agree on. Central banks can set money market interest rates as low or as high as they please just by giving commercial banks whatever amount of excess credit is needed to keep these rates at the chosen level.

Since early 2009, central bankers all over the world have decided, rightly or wrongly, that interest rates should be lower than ever before in history. Moreover, these policymakers made it clear that they will continue to squeeze interest rates down to near-zero, or even negative, levels until next year and perhaps beyond.

But this obvious answer to the interest rate conundrum only begs a more interesting question: What accounts for the rock-bottom levels not only of the overnight interest rates that central banks set directly, but also the long-term rates that depend on the willingness of pension funds, insurers and private investors to tie up their savings for 10 years or more in government bonds?

If investors were absolutely confident that short-term rates set by the central banks would remain near zero for many years ahead, then the seemingly paltry returns — varying from 2.6 percent down to 0.6 percent — on 10-year bonds issued by the U.S., European and Japanese governments would seem generous. Rational investors would be happy to lock up their money for a decade at these rates. But why are investors as confident about the persistence of near-zero interest rates as today’s low bond yields seem to imply?

anatole  -- ecb headThere are two possible answers, reflecting diametrically opposite economic views. The pessimistic view is that the world economy since the 2008 financial crisis has settled into a “new normal” of weak growth and negligible inflation or even falling prices. Whatever causes they attribute for this economic ice age — financial fragility, demographics, stagnating productivity or the unintended consequences of the post-2008 monetary experiments — proponents of the new normal agree that central banks will keep interest rates near zero for most of the next decade. So today’s historically low bond yields will offer investors much higher incomes than they will be able to secure in future years.