Current interest rate levels are not a temporary phenomenon. We do not expect a rate hike for several years, and even beyond that, increases are likely to be very modest.

Since the financial crisis more than 10 years ago, we have had very low interest rates by historical standards. In the beginning, that was widely seen as the result of an extraordinary policy response by central banks caused by the extraordinary depth and length of the crisis. However, it is increasingly clear that the decline in interest rates is not so much a remedy against a short-term lack of demand in the economy as it is a structural shift in the global economy. The implication is that there is no reason to expect much higher interest rates in the coming years.

The economic recovery in the euro area has lasted for more than six years, and the economy is not far from its potential output and employment. Yet interest rates are still at record low levels, and nothing suggests that is about to change. Inflation, especially core inflation, is well below the ECB's target, as are inflation expectations. We expect inflation pressure to increase, but only very slowly. Our interest rate forecasts cover the next 12 months, and we do not expect any rate hikes over that period, but it seems likely that it will be much longer than that before inflation has increased enough to warrant higher interest rates. The most likely scenario, in our opinion, is a rate hike in 2022 – of course, with great uncertainty.

We are close to the natural rate

Actual short-term interest rates vary as central banks raise or cut them according to their assessment of the business cycle and inflation outlook. But they are usually seen to be set relative to a ‘natural' or underlying level of interest rates. This natural rate is the one that would prevail in a neutral cyclical situation and it is basically determined by supply and demand for savings and investments. Larger savings will lower the natural interest rate, larger real investments in production capacity and housing will increase it. The natural interest rate cannot be observed directly, it must be estimated from looking at the behaviour of the economy in the past, and such estimates can vary considerably depending on the choice of methods and models. For the euro area, most estimates currently indicate a real natural interest rate of between -1 and 0 percent.

If inflation is, and is expected to be, close to 2% as the ECB targets, that implies a natural short-term nominal interest rate around 1.5%. However, inflation in the euro area has only been 1.3% on average over the past 10 years, and core inflation is currently even lower. Over the coming years, we expect inflation to increase very gradually, but not all the way up to 2%. At the same time, we expect the factors that have pushed down the natural interest rate to become even more pronounced, especially the demographic factors. Hence, our call for the ECB deposit rate is 0.5% five years from now - with a plus or minus depending on the cyclical situation at the time.


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