A Prolonged Period of Low Interest Rates: Unintended Consequences

We examine the potential adverse effects of a prolonged period of low interest rates on financial stability from multiple perspectives. First, we provide a unique comparison of natural rates of interest estimated using two approaches - with and without financial factors - for six large European countries inside and outside the euro area. The results indicate that the need for monetary policy easing or tightening may differ across economies and over time. Financial factors and macro-financial linkages further amplify these differences, implying that business and financial cycles may not be well synchronized across countries, with the financial cycle being more desynchronized. We then provide a comprehensive review of the empirical literature, allowing us to identify and categorize financial vulnerabilities which may be created and fueled by low interest rates. We discuss a situation in which a prolonged period of low interest rates may lead to a point of no return by contributing to higher indebtedness, overvalued asset prices and underpriced risks, resource and credit misallocation, and lower productivity. With respect to all of that, we offer a few monetary policy considerations, including a short discussion of the role of macroprudential policy. Specifically, we suggest that (i) monetary policy should act symmetrically over the medium to long term, (ii) both the short-term and long-term costs and benefits of pursuing accommodative or restrictive monetary policy should be accounted for, and (iii) monetary and macroprudential policies need to be coordinated, and their interactions should be accounted for in order to find the best policy mix for the economy.