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What do Current Low Interest Rates Mean?

September 14, 2012

Good economists don’t predict. Good economists interpret market predictions. Interest rates have confused me personally for awhile now. I honestly thought they’d be much higher by now, but the efficient market hypothesis suggests I’m wrong, and who am I to argue?

The economy has been rather depressing for around 4 years. Interest rates are at astounding lows, both for Treasuries and corporate debt (around 3% for long term bonds). Given that historically, inflation has been 2-3% since the great moderation, you’re looking at very low yields. Interest rates are a price; the price of debt, and prices are determined by supply and demand.

Supply of loanable funds is determined by people who lend out money – investors, bankers, and central bankers. Central bankers typically don’t make direct loans, but by increasing the demand for various assets, they increase the supply of loanable funds. People save for particular goals and also as a buffer against negative shocks. Some goals include retirement, buying a house or a car, or college. The biggest savings goal, by far, is retirement, which leads to demographic savings trends. Because the baby boomers are so close to retirement now, they have a lot of money to invest. If people expect inflation, they may demand higher returns to lending out their money, which is known as the Fisher hypothesis. If people expect 2% deflation, they might be happy to sit on Treasuries with a near 0% nominal yield, but if they expect high inflation, they will try to buy real resources, such as durable goods, to protect themselves from losing purchasing power. Low nominal interest rates partially stems from low expected inflation.

10 Year Market Expected Inflation (TIPS Spread)

Demand for loanable funds comes from people who want to borrow money to finance consumption and businesses which borrow money to finance investments. Right now, households are not looking to take on more debt, and in fact, are rapidly deleveraging. Corporations are likewise building up huge cash reserves, presumably to fund future investments. But even highly innovative firms like Google and Apple, which presumably could be doing a lot more investment, have been simply holding onto the cash instead. Perhaps there is a high amount of uncertainty. If firms simply thought the future was going to be crappy, presumably they’d pay more dividends. Holding onto it implies that they expect to be able to do something with it eventually. With inflation running below 1%, the cost to holding cash is quite low anyway.

If firms can’t come up with profitable investments, even with interest rates approaching 0% in real terms, that suggests that the economy is more messed up than a lot of people think. Stocks and bonds probably won’t return much, and buying Treasuries that have negative yield is kind of silly. So what is one to do? Perhaps the best investment anyone can make is paying off high interest debt, which if you are not planning to default, is a good way to increase your future net wealth. If you have no debt, you could invest in upgrading to Energy Star appliances, insulate the house better, improve roofing, improve HVAC, human capital, or buy durable goods. There are many ways to save which don’t involve stocks or bonds.

Update: Maybe it’s all just part of a trend.

Further Reading:
Angus comments.
Deleveraging is driven by defaults

2 Comments leave one →
  1. silver price permalink
    September 19, 2012 11:11 pm

    Understanding the Underlying Concepts From 1980 through 1984, inflation plunged from 9.2 to 3.7 percent. However, because the nominal rates on Treasury Bills fell only from 11.5 to 9.6 percent over the same period, the real, inflation-adjusted returns on Treasury Bills actually rose from 2.3 to 5.9 percent. During one of the 1984 campaign debates, incumbent President Reagan boasted that his administration had successfully lowered interest rates. A few minutes later, his challenger Walter Mondale insisted that interest rates were at their highest point in decades. While these seemingly contradictory claims confused most viewers, economic students around the world knew both candidates were correct. Nominal rates were down — just as Reagan had claimed — while real rates were up — just as Mondale had countered.

    • September 20, 2012 1:50 pm

      I am not very familiar with that time period. I think one explanation for why T Bill rates remained high is that perhaps people did not have a lot of faith in the new lower inflation rates.

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