Sunday, August 17, 2008

Why Interest Rates Are So Low

Robert Higgs at the Independent Institute blog asks why interest rates are so low. This is a particularly interesting question with regard to Treasury bills which yield less than 2%.

The most straightforward and simplistic answer is that interest rates are low because the Fed says that they should be low. But this leaves out how they achieve this. Ultimately, if markets want higher interest rate then this requires an increased money supply.

There isn't one, but several explanations for this. During the Fed's initial rate cutting cycle between August 2007 and March 2008, the explanation for this was mainly increased money supply growth. In recent months, money supply growth has slowed, but interest rates remain low for Treasury bills and similar safe securities.

The reason why money supply growth has slowed is because the Fed doesn't target it. It targets interest rates. And if other factors put a downward pressure on interest rates, this means that money supply growth automatically slows.

Several factors have contributed to keeping interest rates low, despite falling money supply growth (or to be more technically correct for reasons described above, these factors have caused money supply growth to fall given the interest rates set by the Fed). One is increased risk aversion. This is evident in rising corporate bond yields, with Baa corporate bonds now yielding less than before the Fed's interest rate cuts started, implying sharply increasing risk spreads. Increased risk aversion, it should be noted, will at the same time contribute to higher interest rates on assets that are considered risky and to lower interest rates on assets that are considered safe (Because investors increase their demand for them), such as Treasury bills.

Falling asset values have also made many households and companies less willing to borrow and spend, also putting downward pressure on interest rates. On the other hand, the sharp increase in the budget deficit caused by the weak economy, the tax rebates, the bailout of banks and increased military spending have had the opposite effect.

Furthermore, the high oil prices have caused the size of Sovereign Wealth Funds to increase, which means increased demand for various forms of investments, including U.S. government bonds. This is particularly true for the Arab Gulf States who have a fixed exchange rate vs. the U.S. dollar and so must buy dollar assets to maintain this. The high growth of the foreign assets of the Chinese central bank has had similar effect.

Finally, it seems likely that inflationary expectations have fallen among investors, while an increasing number are also bullish on the dollar. Whether or not these expectations of future inflation and exchange rate movements will turn out to be true is irrelevant. What matters for demand for U.S. government securities are expectations. Lower inflationary expectations can be seen in the falling spread between nominal government securities and TIPS (Treasury Inflation Protected Securities), as TIPS yields have risen while nominal yields have been flat. There are reasons to take this indicator with a grain of salt, but it is also confirmed by the decline in the price of gold, the traditional inflation hedge.


Anonymous Anonymous said...


I agree with your analysis. It leads to this quetsion: What will the Fed do from here? Given they aren't targetting money supply, they may very well raise rates at some pont in the future, whch could lead to a shrinkage of the money supply.

Who would have thought this 6 months ago?

5:34 AM  
Anonymous Anonymous said...

"This is evident in rising corporate bond yields, with Baa corporate bonds now yielding less than before the Fed's interest rate cuts started, implying sharply increasing risk spreads."

is this a typo?

5:11 AM  

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