One of the most striking features of today’s economy is that interest rates, on everything from bank loans to Treasury bonds, are at 50-year lows. Federal Reserve actions to stabilize the financial system and stimulate economic growth contributed importantly to these low rates. There is much talk lately of the need for an exit strategy to normalize interest rates and head off the return of inflation. However, “normal” interest rates are likely to be lower than most people expect, especially if the Congress and the administration can agree on a long-run strategy to control fiscal deficits.
Some have argued that the Fed pushed interest rates too low earlier this decade, feeding the financial excesses that caused the crisis. However, interest rates have been trending down since the early 1980s and this long-term downward trend in interest rates includes many more rates than those that are closely controlled by the Fed, including longer-term rates and corporate rates.
The interest rate on 10-year Treasury bonds averaged 10.6 percent in the 1980s, 6.7 percent in the 1990s, and 4.6 percent in the current decade even without including the exceptionally low rates during 2009. The real 10-year interest rate, which subtracts a survey measure of 10-year inflation expectations, averaged 5.3 percent in the 1980s, 3.4 percent in the 1990s, and 2.1 percent between 2000 and 2008. Similar patterns prevail across the advanced economies, reflecting the integration of their financial markets.
What has driven the trend toward lower real interest rates?
A number of factors appear to be responsible. First, investment demand has declined in the advanced economies as their growth rates have slowed. Slower economic growth reflects slower population growth throughout the advanced world as well as the winding down of the productivity “catch-up” in the non-US countries toward US levels. Second, lower marginal tax rates and declining rates of inflation made advanced-country sovereign bonds and insured bank deposits more attractive to savers. Third, over the past decade, the governments of many Asian economies have funneled unprecedented amounts of capital into advanced-country financial markets in an effort to hold their currencies down and maintain export-led growth. Fourth, commodity exporters, especially oil exporters, saved a high fraction of their revenues when commodity prices were high earlier this decade. Despite notable swings during the past 30 years, fiscal policy probably had only a small net effect on interest rates. Both US and total Organization for Economic Cooperation and Development (OECD) net government debt as a share of GDP were about the same in 2008 as in the mid-1980s.
What are the prospects going forward? Labor force growth is likely to slow further, adding to downward pressure on interest rates. The US Bureau of Labor Statistics projects that the US labor force will grow 0.8 percent per year between 2006 and 2016, compared to 1.2 percent between 1996 and 2006. The OECD also projects declining labor force growth rates in most other advanced economies. It seems unlikely that income tax rates and inflation rates will continue to decline from current levels, so this effect on interest rates should be neutral. Saving by commodity exporters has declined over the past couple years as commodity prices have fallen, but if commodity prices rise during economic recovery, these savings could rebound and help to hold down interest rates. In Pittsburgh, the leaders of the G-20 nations agreed on the importance of rebalancing global growth, which would require lower saving in Asia and thus tend to raise interest rates. But such a change, if it happens, would likely be phased in over time. Public net debt is projected to grow significantly as a share of GDP in the United States and other advanced economies, which would put upward pressure on interest rates, although a long overdue rise in US household saving is working in the opposite direction.
It is not clear if the net effect of these factors will be to lower or to raise interest rates. However, if advanced-country budget deficits are put on a sustainable path (another G-20 promise) there is a significant probability that interest rates will remain low for some time to come. What would such an outcome mean for US economic policy?
First, the Fed would not need to raise the interest rates it controls by as much as some observers expect as the economy recovers. Second, low interest rates would help ameliorate the burden of rising US public debt. Third, if low interest rates earlier this decade fed the financial excesses that caused the crisis, as many believe, then we need to craft a regulatory framework that enables our financial system to operate safely in an environment of low interest rates. In particular, macroprudential regulatory safeguards such as countercyclical capital and margin requirements may be helpful to stabilize periods of financial excess, leaving Fed interest rate policy to focus on maximum employment and price stability.
Source: International Monetary Fund and Federal Reserve Bank of Philadelphia.