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Robert Samuelson

The Mystery of Low Interest Rates

By Robert J. Samuelson
Wednesday, March 2, 2005; Page A17

Something strange happened on the way to higher interest rates: They declined. We're talking about rates on long-term mortgages and bonds. These rates truly affect the economy, because they influence housing and business investment. Most economists expected them to rise. But no. Last June rates on 30-year fixed mortgages averaged 6.29 percent; now they're about 5.7 percent. Federal Reserve Chairman Alan Greenspan recently called the declines a "conundrum.'' Equally puzzling is whether the declines guarantee a healthy economy -- or suggest a speculative "credit bubble.''

To judge the weirdness, consider all the forces that should have raised rates. For starters, there's the expanding economy; that should increase credit demands. Next there's the Fed's policy of squeezing credit supply. Since last June the Fed has raised the Fed funds rate from 1 percent to 2.5 percent. (This rate, the only one the Fed controls directly, applies to overnight loans among banks. Higher rates imply that the Fed is striving to curb bank credit.) Growing credit demand meets tightening supply -- rates rise. But they haven't. It's "highly unusual'' for long-term interest rates to fall "despite a better economy and [Fed] tightening,'' says Mark Zandi of Economy.com.

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But wait, there's more. Exploding federal budget deficits have also bloated credit demands. Since 2001 deficits have totaled $948 billion; and deficits are projected indefinitely. Still, Treasury bond rates have dropped. In January 2001, when George W. Bush became president, the rate on a 10-year Treasury bond was 5.16 percent. Now it's about 4.25 percent.

Theories abound to explain the mystery. Here are three, courtesy of economist David Wyss of Standard & Poor's. Each has flaws. Cautious companies, it's said, aren't borrowing much for new investment. True. In September the debt of nonfinancial corporations was up only 3.3 percent from a year earlier. But strong household and federal borrowing (up 9.8 percent and 9.7 percent) have offset weak business borrowing. Another theory is that foreigners have rescued us by investing huge sums in U.S. bonds and mortgages. Through September, foreigners had provided 32 percent of the money raised in U.S. credit markets in 2004, up from 14 percent in 2000. But foreign lending was also huge in 1996 (28 percent), when interest rates were higher. Finally, today's low rates may mainly reflect low inflation; lenders don't require extra compensation for the erosion of their money. True. But inflation expectations haven't changed much recently. How could they explain the latest drop in rates?

There are also gloomier theories. Economist John Makin of the American Enterprise Institute says that low long-term rates signal fears of a weakening economy. A weaker economy would presumably mean less inflation and credit demand -- both justifying lower long-term rates.

But why worry about low rates? After all, they help borrowers, and if the economy is unexpectedly weak, they might prevent a recession. However, artificially low rates can also prompt overborrowing, creating inflation or speculative price increases in whatever is being bought on credit -- land, stocks, homes. Sooner or later prices stop rising and (perhaps) start declining or even crash.

Among worriers, the fear is that cheap credit has created a housing "bubble.'' In the year ending in September, average U.S. home prices rose 13 percent, reports one survey. In Nevada they rose 36 percent, in California, 27 percent and in Florida, 20 percent. Higher housing prices have supported consumer spending -- people borrowed against home values -- and free-spending Americans have bolstered the U.S. and global economies. If the cycle reversed, the consequences might be grim. Falling home prices. Sickly consumption. Global slump.

In the critics' story, the Fed plays the villain. It fostered artificially low mortgage and bond rates through cheap short-term credit. Hedge funds and investment banks embraced the "carry trade'': They borrowed short-term funds at 2 percent or 3 percent and invested in longer-term securities with higher rates. Pension funds and insurance companies shifted from short-term to long-term securities, because short-term interest rates were so low. The flood of money depressed rates on most bonds and mortgages. Indeed, the "spreads'' -- the gaps -- between rates on Treasury bonds and rates on "junk'' bonds and bonds of "emerging market'' countries are now at historical lows, says Diane Vazza of Standard & Poor's.

But the structure of interest rates -- and hence housing -- is vulnerable to a nasty surprise and also to the Fed's present policy of raising short-term rates. So say critics. Greenspan seems less agitated. A growing economy, he testified recently, can absorb higher rates. Localized drops in home prices might occur, but nothing "resembling a collapsing bubble.''

All this attests to our economic ignorance. There are no simple rules (budget deficits, for instance) to explain interest rates. My view is that low interest rates are mainly a good sign. They reflect not only low inflation but growing confidence that it will stay low. We may be reverting to the 1950s, when this was the norm. In 1959 the rate on the 10-year Treasury bond averaged 4.33 percent. This is a reassuring notion; it could also be wrong.

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