RDP 2022-08: The Consequences of Low Interest Rates for the Australian Banking Sector 2. The Low Interest Rate Environment

Before exploring the consequences of low interest rates, a brief digression to frame what is typically meant by the ‘low interest rate environment’. Rather than referring to rates that are temporarily low, the low interest rate environment typically refers to a situation in which interest rates are expected to remain low for an extended period. This low-rate environment is typically discussed in reference to the ‘neutral’ interest rate – loosely defined as the real policy interest rate that will endure once all temporary (i.e. business cycle) shocks have worked their way through the economy. With a constant inflation target, if the neutral rate is low by historical standards, the nominal policy rate will also tend to be lower than has historically been the case.

A stylised fact common across advanced economies is that the neutral rate is estimated to have fallen significantly from the mid-20th century (Holston, Laubach and Williams 2017). The rate of descent may have slowed in the late 20th century, but has returned in earnest since the turn of the century (or just before). Common explanatory factors include the ageing population, productivity slowdowns, rising income inequality, increased public debt and increased risk aversion. A recent study with a model that nests most of these explanations suggests that they all have an important role to play in the United States (Platzer and Peruffo 2022). Moreover, these authors predict only a small increase in the future neutral rate from its current level to around 1 per cent, which is still 3 percentage points below the level estimated for 1950.

The neutral rate in Australia is estimated to have followed a similar profile to other advanced economies. Estimates suggest the neutral rate in Australia fell from over 3 per cent in the early 1990s to around 1 per cent around the mid-2010s (McCririck and Rees 2017). Recent updates of this work suggest the neutral rate in Australia recently fell further, to around zero per cent (Saunders 2022), before increasing back towards 1 per cent (Ellis 2022). Therefore, even though short-term interest rates are expected to continue their upward trajectory in the near term, it behoves us to learn from the recent period of low interest rates given the high probability that they will return at some point in the future.

A feature of neutral rates that is particularly important for the analysis in this paper is that, all else equal, neutral rates tend to fall when the spreads banks set between their lending rates and the policy rate increase (because it is the rates people pay that ultimately matter for economic activity). Given that increases in these spreads – caused by increases in the difference between banks' debt funding costs and the policy rate (Brassil, Cheshire and Muscatello 2018) – are suggested to explain much of the decline in Australian neutral rates following the global financial crisis (McCririck and Rees 2017), changes in the interest rates borrowers are expected to pay in the long run may be more muted than what is suggested by the recent fall in the neutral rate. Conversely, the relatively stable neutral rate estimated for the mid-1990s to mid-2000s may have underestimated the fall in long-run expected borrowing rates as lending spreads declined significantly following deregulation of the financial sector (RBA 2014).