Interest Rate Levels

Yesterday I mentioned that low interest rates on long-term debt reflected weak growth expectations in the US economy. Bernanke gave a speech on this exact topic recently–for more detail definitely check it out.

First, to recap from yesterday–interest rates are not being kept artificially low by the Fed–the trajectory of long-term rates in multiple countries with varied monetary policy, the end of QE2 (and lack of rate spike), and the lack of inflation in the US all signal that rates are not being kept artificially low by the Federal Reserve.

Instead, long term rates are a function of 3 things: expected inflation over the duration of the security, the expected path of short-term interest rates, and the term premium. The term premium is basically just a small price that the market demands for taking on the added volatility of long-term debt. However, the US also has the global reserve currency–in times of economic turmoil, foreign central banks and global investors need safe assets, and they buy US treasuries. With the Euro-zone turmoil of the last several years and the global financial crisis, the global demand for safe assets has pushed the US long-term rate premium to (possibly) negative levels, contributing to lower interest rates.

Outside of the rate premium, expected inflation and expected path of short-term rates make up the rest of US long term interest rate pricing. Expected long-term inflation in the US is about two percent. This reflects the fact that the US Federal Reserve has a great deal of price stability credibility–investors believe the Fed can and will keep inflation at its two percent target.

Last, long term interest rates reflect the path that investors expect short term rates to take over the duration of the security. Because the Fed sets short term rates in response to macroeconomic conditions, basically long-term interest rates are, in part, a function of what investors think growth will look like over the duration of the security. If investors expected growth to be strong, they would anticipate that the Fed would raise short term rates in the near future, leading them to demand higher prices for long-term interest securities. Instead, long-term interest rates are ~2%. If we remember that expected inflation is  2%, this means that investors are demanding no additional rate premium and expect short term rates to stay near zero for the foreseeable future. Investors expect short term rates to stay near zero because they expect growth to continue to be weak, necessitating loose monetary policy. Thus, long-term interest rates are low because expected inflation is low (near 2%) and investors expect growth to be weak to the extent that average short term rates moving forward will stay near 0.



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