I’ve been meaning for a long time to collect my thoughts about US interest rates, and where they are and should be going. As is often the case, I’m largely in agreement with Paul Krugman, at least as far as long-term rates are concerned. On the other hand, I’m a bit more hawkish in relation to short-term rates than Brad DeLong, with whom I agree on a lot of things.
I’m planning on reworking this piece as I have new thoughts, and in response to comments. so please treat it as a work in progress.
Warning: long and boring (but maybe scary) post over the fold.
h4. Interest rates
Much of the discussion has the same confused character as debates about the desirability of budget deficits. The essential problems are similar. In the short run, both interest rates and budget deficits can be controlled by governments (central banks count as part of government for this purpose). Other things being equal, low interest rates and budget deficits tend to stimulate economic activity, and are therefore appropriate when the economy is in recession[1].
In the long run, however, government budgets must balance[2]. Similarly, interest rates must be determined by the intertemporal consumption plans of consumers and the available opportunities for investment. The problem is that the long run can be a very long time coming and no-one knows when it begins. Even the 10-year bond rate is clearly affected by judgements about the policy stance of the central bank.
The link between short-term rates and long-term rates can be seen by considering arbitrage or, as it’s sometimes called, the ‘carry trade’. If a central bank is committed to keeping short-term rates at, say 1 per cent, but market forces dictate a long-term rate of 5 per cent, speculators can make as much money as they want by borrowing short and lending long.
Another way to look at is to note ten years is just (about) 40 terms of 90 days. So, on average, the annualised rate of interest on 90-day loans has to be about the same as the 10-year bond rate, sometimes higher and sometimes lower.
The interest rate problem is therefore really two problems. First, what is a reasonable value for the rate of interest in the long run. Second, given that the short-term rate is currently below the long-term rate, how soon should it be increased.
The first question itself is in two parts. The face-value or nominal interest rate is in part a compensation for future inflation, and in part a real interest rate, reflecting the existence of profitable investment opportunities, and the impatience of consumers. The real interest rate has generally been somewhere between 2 and 4 per cent. Given that savings rates are exceptionally low at present in the US and elsewhere (denoting high levels of impatience) the rate ought to be at the high end of the range, especially if you believe that technological progress has opened up lots of investment opportunities.
As regards inflation, the combination of low short-term rates and exploding budget deficits is bound to produce an acceleration if it persists long enough. Given that there’s a significant chance of a rapid acceleration, and that the bogey of deflation has now largely disappeared, it seems reasonable to pick an average rate of around 3 per cent.
Combining the two suggests that the long-term nominal rate of interest for the US ought to be between 6 and 7 per cent. The ten-year bond rate currently just below 5 per cent and has been below 4 per cent until quite recently, reflecting the influence of very low short-term rates. But the same reasoning implies that, at some point, the ten-year bond rate is likely to overshoot the equilibrium range.
Coming to the short-term rate, there is a trade-off between the need for stimulus now and the inevitable price of higher rates in the future. There’s been a big dispute between those, like The Economist who want to put rates up immediately and those like Brad de Long who want to keep them low while employment remains depressed (one reason may be disagreement about how far the economy is from its ‘natural’ equilibrium).
What would be the consequences of an increase in short-term and long-term interest rates. Higher short-term rates would depress consumption, particularly things like purchases of new cars. This could be problematic for Ford and GM, which are essentially finance companies with a manufacturing arm these days.
But the real puzzle relates to long-term rates and mortgages. Most US homeowners are in the enviable position of having fixed-rate loans which they are free to refinance if they wish. This is an amazingly generous one-way bet, but it’s not clear who is on the other side of it. The securitization and hedging of mortgages has become so complex that no-one knows who really holds them.
If interest rates rose a lot, refinancing would stop. Moreover, homeowners would be forced to stay put, since moving would entail taking on a new mortgage at a much higher rate. The big problems, though, would be on the other side of the market, where the mortgagees would have assets that, on standard analysis might have halved in value. I discuss this a bit more here.
There are a lot of other scary possibilities relating to derivatives markets. These haven’t been seriously tested since the big expansion of the 1990s. Most people seem to think everything will be OK, but no one can be sure.
fn1. Some economists (for example, supporters of the new classical model) dispute this, but I don’t intend to debate this point here.
fn2. Under standard accounting conventions, governments can run deficits forever, but in economic terms, either the budget must balance, or public debt will follow an explosive path leading inevitably to repudiation.
John Quiggin 
John, your analysis is missing something, and that is the exchange rate. If investors jump out of long bonds and this causes a big fall in the exchange rate, then this normally should mean that long rates go up less than they would in a closed economy. But it all depends on what happens to FX market expectations after the exchange the falls. If the expectation is that after a one off fall, the exchange rate will climb back up, this should stop long rates going up too much.
But if the expectation is that the exchange rate will keep on falling, then long rates will go up by even more than they would in a closed economy. We are then in the very ugly scenario where the US bond prices and the exchange rate chase each other down. This is the stuff of Latin American banana republics.
In normal circumstances, I would think the first, non-scary scenario will unfold. The problem is that US Budget deficit is so big, at 6% of GDP and the combination of Bush’s tax cuts and military spending will keep it big. The supply of bonds is going up at a great pace. The demand for them is very fragile. The owners of US bonds could easily panic. If there’s a rush to the exits in the bond markets, then it could be a nightmare.
If we add bank failures from derivatives markets, then it’s a nightmare squared.
Scary stuff, gentlemen, but a couple of points might ease your fears:
1) US bond yields aren’t driven by the demand/supply balance of just US savings. Your assertion that, “Given that savings rates are exceptionally low at present in the US and elsewhere (denoting high levels of impatience) the rate ought to be at the high end of the range…” assumes that the US doesn’t have access to those hard-saving Japanese, Germans, Italians, etc. that DO have high savings rates. Those savers continue to invest in US assets (like bonds) because they have confidence in the returns and the USD. Shake either one of those and you have a problem, but it’s not correct to say that US yields must go higher because US consumers don’t save. As Uncle Milton points out, exchange rate expectations have a big role to play.
2) As JQ points out, the US 10-yr bond yield was low, and has ALREADY risen. In June last year, the yield was around 3.10%. Now it’s around 4.75%, and has risen about 0.50% in just the last month. The strength in recent US economic data suggests that yields will go higher as the market factors in Fed rate hikes. US money market yields imply a better than 90% chance of a 25 basis point rate hike in June.
3) The refinancing boom has come and gone. US consumers refinanced their fixed-rate mortgages with a vengeance all through 2001-2003, and this helps to explain why they have been able to maintain consumption growth at a high rate.
4) The US mortgage market isn’t as opaque as you suggest. The market is heavily securitised, and the end-investor is your typical bond fund, insurance company or other investor seeking high quality (i.e. low risk) fixed-interest investments. Have these guys lost money on their bonds from the rise in yields? You betcha, but that’s the nature of the fixed-interest market. If they were worried, they hedged (probably using derivatives, but that’s another story…).
5) The US mortgage market has relied heavily on securitisation for more than three decades, and has gone through several monetary cycles. Yes, a sharp rise in bond yields hurts bond investors, but it’s a known risk in the industry.
The key question is, are we going to see a yield shock (e.g. yields rise 2-3% within a year) like we did in 1994, or will we see a more gradual increase in bond yields? If it’s the latter, then we’re not facing the apocalypse. If it’s the former (unlikely at this stage given the lack of inflationary pressure, and the Fed’s generally dovish comments) we’re looking at a very nasty period for both bond and equity markets, and a severe knock to the global economy.