Why Are Interest Rates This Low?

Interest rates for long-term gov't guaranteed loans (yields on T-Bonds in the US) having fallen back to where they were when Greenspan in February called the low rates a "conundrum". Hence an opportunity to get back to the discussion on why most countries today have such an unusually low interest rate levels, at odds with economists repeated predictions of higher rates. For us in Sweden, this discussion is important for our central bank, the Riksbank's, whose board sees their interest rate levels as "basically very low", and looks for arguments to hike them in. This is troublesome, as politicians and some leading economists are calling for cuts amid a faltering recovery in the labor market and low inflation rates. Nevertheless, one board-member, perhaps by the market considered as the most hawkish, recently managed to discuss the subject in a speech called Unusual market rate developments, much influenced by that of Greenspan mentioned above with my comments here.

Several different reasons for low rates have been put forth, and it is easy to agree that factors like low expected inflation, central bank inflation targeting in increasingly productive economies, and decreased need for investments in an industry that manages to increase output while slimming production are important. Asian central bank buying and currency pegging is also to some extent helpful in explaining the low first world rates, but do these factors really have a bearing on the world interest rates, or are they merely increasing the spread between the effective interest-rates in e.g. China and the USA? But one factor, the hedge fund buying, long-standing member of the usual suspects, should be off the list since bond-yields now probably is seen as too risky, with all its variation (in the 4.0 - 5.0 % range for the 10-year treasury) for the return, especially in the view of decreased carry (aprox. bond-yield minus repo-rate). A new explanation has however materialized: pension reforms in Europe, and possibly elsewhere, that requires life insurers to match their liabilities, i.e. buy long and even ultra-long bonds.

But on the other hand are factors that acts in the other direction, interest rates are buoyed by consumers, most notably in the USA, that are rapidly expanding their debt, and by most of the largest world-economies' governments that are borrowing at a pace corresponding to several percent of total production, GDP.

All in all, the old rule of thumb that the rate net of inflation, the real rate, should correspond to the expected economic growth rate, does simply not work that well these days, as was mentioned in the Riksbank speech. Even though it is a rule with quite some support in economic theory, one should find good reason to examine, and perhaps overhaul it, today. Before, I have done so from several perspectives concerning households investment in their own human capital, skills and education. Today it should be enough to concentrate at the households financial savings, as the production perspective has, at least when it comes to the companies, been discussed in e.g. the Riksbank speech mentioned above. According to the rule of thumb, we save when we see worse times ahead, and borrow when the future looks brighter, to smooth out variations in lifetime consumption. Theoretically, we are assumed to optimize derived utility, which is supposed to be a smooth function of consumption with declining steepness.

In everyday life, at least in a place that has industrialized rapidly, consumption smoothing seems not to be on all household's agendas. The rule is rather that you should save while you can if you can, at least if you talk with people in older generations. And this rule was probably rational in the old days when saved money could save your life in times of economic hardship. Furthermore as we know that - or at least assume in policy-making regarding pensions - life-time saving decisions by individuals are not rational (a claim that is made probable by the lack of learning - you only retire once), the save-if-you-can rule might be inherited by younger generations. Theoretically, if your utility function displays a sharp knee between a steep line at poverty-level consumption and a flat one above, it might be rational to save, even at low or zero rates, until your risk of dropping back into poverty becomes low. Let us hence revise the rule of thumb:

A. If the representative household faces little risk of poverty and has distanced itself from traditional views on savings, real rates correspond to expected growth.

B. If the representative household still holds the traditional views on savings, real rates are much lower than you should expect in A.

And if we take the representative household to be one that belongs to a group that is responsible for a large part of world consumption, we should be much closer to the low-rate regime in B. than the old regime where the world outside USA, Japan and Europe really didn't count.