Yields on ten year US Treasuries peaked in July 1981 at over 15%, as the graph below shows; while today, yields are just above 2%. Yields for shorter maturity T-bills, Canadian government bonds, and real interest rates (reflecting inflation expectations) follow a similar decline. The decline in interest rates, both nominal and real, has been a word wide secular phenomena. What explains the decline in interest rates since 1981? And importantly for asset valuations as well as financial market returns, where are interest rates headed? In this post, I explore some perspectives that attempt to address these questions.
An explanation for the decline in interest rates is the global savings glut hypothesis made popular by Ben Bernanke in 2005 (here). Mr. Bernanke states:
To be more specific, I will argue that over the past decade a combination of diverse forces has created a significant increase in the global supply of saving--a global saving glut--which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today. The prospect of dramatic increases in the ratio of retirees to workers in a number of major industrial economies is one important reason for the high level of global saving.
Bernanke claims that the high world savings rate, caused partially by the increase in the ratio of retirees to workers, helps explain both the current account deficit in the United States as well as low interest rates. The problem with this view is that since the late 1970s, the savings rate for the world as a whole has declined slightly. Hardly a savings glut.
Robert Barro, in an NBER Working Paper (here), summarizes the determinants of the rate of interest as follows:
In a world of integrated capital markets, the price of credit - which I measure by short-term expected real interest rates - is determined to equate the world aggregate of investment demand to the world aggregate of desired national saving.
The rate of interest, or the price of credit, is determined by the intersection of the supply of desired savings and desired investment, shown in the diagram below. The decrease in interest rates since 1981 could therefore be explained by reduced investment demand, as well as an increases in savings.
There are problems with the savings and investment model: desired investment is not the only source of credit demand; while desired savings is not the only source of credit supply.
A large portion of interest bearing financial assets have little to do with investment expenditures, but still result in a demand for credit. For example, government debt is mainly used to finance government consumptions (i.e. teacher salaries), not government investment (i.e. roads and schools). As well, most home mortgage debt finances the purchase of existing homes that result in no investment expenditures.
Savings is not the only source of credit supply. In a monetary economy, credit is mostly supplied by loans which are issued by financial institutions that intermediate between savers and borrowers. Savings is not necessarily required for a bank to supply credit as loans can be created out of thin air via the banking system's role in money creation. Even without money creation by the banking system, savings as defined by national accounts, is not necessary for credit to be supplied by savers. For example, an economy with 100% of output consumed, with no investment, and therefore no savings as measured by national accounts, would have credit markets as there would be savers and borrows, just no net saving for the economy as a whole.
Monetary policy can control the amount of money the banking system creates in order to meet the central bank's policy objectives given the influence of money on aggregate demand. This is primarily performed by the central banking setting short-term interest rates. The decline in interest rates since 1981 may be explained, in part, because central banks were required to reduce short-term interest rates to lower and lower levels in order to meet central bank policy objectives, as a result of some unexplained structural change to the economy? As markets increasingly expected this to continue, the market`s forecast of future short-term interest rates declined, impacting long term interest rates (as long term-rates are mainly based on expected future short-term rates).
A thought provoking paper from the Bank of International Settlement (here), by Claudio Borio and Piti Disyatat, entitled, Global imbalances and the financial crisis: Link or no link?, emphasizes the importance of gross financial flows as well as monetary factors in the determination of interest rate. Specifically, they state:
The interest rate that prevails in the market at any given point in time is fundamentally a monetary phenomenon. It reflects the interplay between the policy rate set by central banks, market expectations about future policy rates and risk premia, as affected by the relative supply of financial assets and the risk perceptions and preferences of economic agents. It is thus closely related to the markets where financing, borrowing and lending take place. By contrast, the natural interest rate is an unobservable variable commonly assumed to reflect only real factors, including the balance between ex ante saving and ex ante investment, and to deliver equilibrium in the goods market. Saving and investment affect the market interest rate only indirectly, through the interplay between central bank policies and economic agents’ portfolio choices.
The paper corroborates many of the points made above and recommends a more systematic inclusion of monetary and financial factors in the current macroeconomic paradigm. I agree; and this needs to happen before we can understand the secular decline in interest rates and begin to answer where interest rates are headed.