Article written by N. Gregory Mankiw
Over the past for decades, which included the great recession of 2008 and the dot com bubble of 2000, one fact stands out as most puzzling: the large and steady decline of interest rates.
Consider what has happened over the course of time to three key benchmarks:
In September 1981, the 10-year Treasury note yielded over 15%. Today, it yields less than 1%.
Over the same period, the critical short-term rate set by the Federal Reserve, the federal funds rate, has fallen to nearly 0% from the historical 16%.
Finally, the rate on 30-year mortgages has dropped below 3% from over 18%.
What has caused these declines to be so extreme, and what does it imply for personal and public decision-making?
One reason could be a drop in inflation expectations, also known as the “Fisher effect”. Economics Iriving Fisher noted almost a century ago when bond investors expect high inflation, they anticipate that repayment will be made in significantly less valuable dollars, and they demand a higher interest rate to compensate. When expected inflation falls, as it has over the past 40 years, interest rates typically do as well.
It also may be tempting to blame the Fed, and its recent chairs of Jay Powell and Janet Yellen (who the president-elect just selected as the treasury secretary). It is the Fed who sets the rates right ? Well, in the short run, yes, but not in the long run. The Fed aims to set interest rates at levels that will produce full employment and stable prices, sometimes called the natural rate of interest. However, the natural rate is not determined by the central bank but by deeper market forces that govern people’s supply of savings and businesses’ demand for capital. When the Fed decides to lower rates (liked at the onset of the Pandemic), it is acting more as a messenger, telling society that the economy needs them to maintain equilibrium.
Here are several other hypotheses as to why there has been a decline in the natural rate of interest:
- As income inequality has risen over the past few decades, resources have shifted from poorer households to richer ones. To the extent that the rich have higher propensities to save, more money flows into capital markets to fund investment.
- The Chinese economy has grown rapidly in recent years, and China has a high saving rate. As this vast pool of savings flows into capital markets, interest rates around the world fall.
- Events like the financial crisis of 2008 and the current pandemic are vivid reminders of how uncertain life is and may have increased people’s aversion to risk. Their increased precautionary saving and especially their greater demand for safe assets drive down interest rates.
- Since the 1970s, average economic growth has slowed, perhaps because of a slower technological advance. A decline in growth reduces the demand for new capital investment, pushing down interest rates.
- Old technologies, such as railroads and auto factories, required large capital investments. New technologies, like those developed in Silicon Valley, may be less capital-intensive. Reduced demand for capital lowers interest rates.
- Some economists, most notably the New York University professor Thomas Philippon, have suggested that the economy is less competitive than it once was. Businesses with increasing market power not only raise their prices but also invest less. Again, reduced demand for capital puts downward pressure on interest rates.
Which is correct? The answer is an ongoing arena of research, one which is likely a combination of these forces at work.
Investors are now beginning to realize the implications of low interest rates. For example, a balanced portfolio of half stocks and half bonds has historically earned a return of 8.2%, or about 5% after inflation. Mankiw’s guess is that a more plausible projection is an inflation-adjusted return of about 3%. In comparison, The S&P 500 is up by 202% over the trailing 10-year period, while FAANG’s (Alphabet, Facebook, Apple, Amazon, and Netflix) are up a respective 537%, 631%, 978%, 1,700%, and 1,780% over the same stretch.
Some of the causes of lower interest rates might give reason for concern. If they reflect low growth expectations, then counting on strong growth to reduce the debt-to-GDP ratio, much like the U.S. did after World War II, might not be an option.
This means that institutions like universities that use the return on their endowments to fund their activities will need to run a tighter ship. Individuals will also need to rethink their retirement saving.
There are also, however, some benefits of having interest rates so low. Young families looking to purchase a home benefit from the lower cost of mortgage financing.
Some economists have even suggested that with interests rates so low, the government need not worry much about increases in government debt. Even with government debt at its highest point in as a percentage of GDP, servicing it hasn’t been much of a problem. Though is interest rates were to adjust to normal levels, servicing would become much more costly.
In the end, low interest rates are a double-edged sword. We don’t know which edge will end up being sharper.
Works Cited:
https://www.fool.com/investing/2020/12/08/is-wall-street-tiring-of-the-faang-stocks/