2025 Grey Swan – Back to Zero Interest Rates Policy
- By Bilal Hafeez
This article is part of Macro Hive’s 2025 Grey Swan series, where we let our imaginations loose to try and predict low-probability, high-impact events that almost no one expects. You can read the full list here.
The Allure of Low Rates
Low interest rates, especially zero, are alluring. They boost asset prices, make funding the government easier and help keep the public happy. Most importantly, since the global financial crisis of 2008, central banks have become addicted to them.
The average policy rate for the Fed, ECB and Bank of England between 2009 and 2021 was 0.6%, -0.1%, and 0.5%, respectively (Chart 1). During that period, core inflation in the US ran at 2%, at 1% in the euro area, and at 2% in the UK (Chart 2). It was not as if these economies were facing deflation.
It took generationally high inflation for central banks to collectively move off the zero bound. Even then, they were late to start to hiking and quick to cut rates. Remember, the Fed started with a 50bps cut in its easing cycle this year despite core CPI at 3.3%, which was worryingly above its 2% target.
This begs the question as to why the consensus of economists are only expecting modest cuts to neutral in 2025, rather than cuts to zero rates. Before COVID, central banks were comfortable with zero rates when inflation was at 2%, which is where most expect inflation to be in 2025. Meanwhile, market measures of inflation expectations remain well behaved.
On top of this, net government debt as a share of GDP for the US will breach 100% in 2025. It was 43% before the GFC (Chart 3). In the Euro-area, it will grow to 75% (vs 53% in 2007) and in the UK it will grow to 92% (vs 38%). The only reason debt levels have not jumped more since COVID was that inflation eroded the value of the debt. No wonder central banks were so quick to cut rates this year even when inflation remained above their targets.
The icing on the cake would be a recession that prompts a rapid easing to zero. An obvious candidate would be an escalating trade war between the major economies with echoes of the Smoot-Hawley Tariff Act of 1930 that contributed to the Great Depression.
The bottom line is to not be overly dismissive of central banks returning to their addictive ways.
