Central banks are facing a problem – potentially a fatal one. An increasing number of academic studies have emerged that blame central banks for having a much greater influence on the development of long-term real interest rates than mainstream economic thought has previously attributed.
This is no small matter. If the findings of these studies are confirmed, they will necessitate rewriting basic economics textbooks. For example, it would support the idea that highly expansionary monetary policy may not stimulate economic growth or consumption but rather just inflate asset prices, such as stocks or real estate. This, in turn, could widen economic inequality, with all its unfortunate consequences – including political polarisation – a trend now evident in many countries in the West.
Coincidence?
The April 2025 issue of The Review of Financial Studies features a startling insight from Harvard economist Sebastian Hillenbrand. He documents that since the 1980s, the decline in long-term interest rates in the US has been entirely due to their movement within a relatively short, three-day window around the Federal Reserve’s monetary policy meetings.
Economists have long puzzled over what causes this persistent decline in interest rates. While they disagree on the specific causes, there is broad consensus that these causes are outside the influence of central banks – reasons such as changes in demographics, productivity growth or income inequality, which are factors beyond monetary policy’s control. Central banks are thought to influence only short-term nominal interest rates, not long-term real interest rates (‘real’ meaning nominal rates adjusted for inflation).
But how is it that, as Hillenbrand finds, long-term US government bond yields decline exclusively through this cumulation of drops within the three-day window around the Fed’s meetings? And this phenomenon isn’t limited to the US – similar patterns are visible in the UK, France and Germany.
Could it be coincidence? Is the central bank, through its setting of short-term nominal interest rates, just effectively ‘sealing’ a development in the real economy that independently unfolds? And why is it only the central bank that seems to have information about real developments, whereas markets react always in the time around central bank meetings, adjusting bond yields according to central bank’s signals and overall communication?
A self-fulfilling prophecy
Hillenbrand’s argument reveals that blaming central banks for these long-term rate declines is a key to unravelling these puzzles. While central banks set short-term interest rates, they also update and communicate – notably around their policy meetings – their expectations for the long-term interest rate. The market adjusts to these outlooks, most intensively in the days around the meetings, and then incorporates these expectations into bond yields.
If, for example, a central bank signals and communicates expectations of low inflation, low bond yields and low interest rates, the markets tend to believe it – leading to a self-fulfilling prophecy. Low interest rates result because the markets believe they will remain low. Consequently, the central bank can in effect reduce long-term real interest rates, even while only setting short-term nominal rates.
However, a mainstream economist might argue that this is nonsensical – that a central bank cannot arbitrarily influence the evolution of long-term real interest rates. These rates are the result of fundamental factors beyond its influence, such as demographic trends, productivity or income inequality. Thus, if a central bank unilaterally kept short-term interest rates permanently below the natural rate – reflecting the equilibrium level – reality would punish it with runaway inflation. Conversely, if it kept rates too high, the economy would be stifled and slide into recession. Reality tends to punish arbitrary policies – eventually.
Natural interest rate may be irrelevant
But what if the natural interest rate is actually irrelevant from the central bank’s perspective? That provocative idea is explored in an April 2025 study by the Bank for International Settlements. Its authors – Paul Beaudry, Paolo Cavallino and Tim Willems – argue that there may be no actual punishment for central banks’ arbitrary actions in practice.
For example, if a central bank persistently keeps rates below the natural rate, the intended stimulative effect – easier credit for investment and consumption – is only partially realised, while an unintended and often overlooked effect occurs: persistently low interest rates encourage savings and investment, reducing consumption.
Imagine someone saving for their retirement. If the central bank lowers interest rates to boost growth and consumption, that person might instead decide to save even more or invest more in assets like real estate – trying to reach their financial goal despite the lower returns. This counteracts the initial stimulative intent, effectively cancelling out the boost to consumption, as the BIS study finds empirically. The combined effect is roughly zero – only asset prices, like stocks or real estate, continue to inflate.
However, since assets are rarely included in the consumer basket used to measure inflation, central banks keep rates low and continue inflating asset prices. The absence of inflationary pressures related to the consumer basket falsely reassures them that inflation is weak, and this belief – through central bank’s signals and communication – ‘infects’ the entire market, leading to even more inflated asset prices and making housing less affordable.
Have central banks made a mistake?
We observed something similar during the Czech National Bank’s exchange rate commitment in the past decade. Although the CNB tried to stimulate domestic consumption and inflation by maintaining extremely low interest rates and even setting the exchange rate floor, weakening the Czech koruna through foreign exchange purchases, it long failed to do so.
Instead, it mainly encouraged the rise in real estate prices; when it pushed bond yields into negative territory, it caused mortgage rates to fall to historic lows, stimulating demand for real estate domestically and, because of much weaker koruna, partially also from abroad.
But it is not just the CNB. If it is central banks – and not independent real factors – that determine the development of long-term real interest rates, then it must be acknowledged that their unconventional interventions over the past decade – such as setting exchange rate floors and pegs, negative interest rates or quantitative easing – were largely or entirely a serious mistake.
A mistake that unnecessarily inflated asset prices, thereby further enriching the already wealthy without helping the broader economy. The transfer of wealth from the already poor to the already rich continues to polarise politics and a significant part of western society.
Lukáš Kovanda is Chief Economist at Trinity Bank.
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